The Bank of England published a staff working paper that models euro area business cycle fluctuations using a large quarterly dataset and concludes that most cyclical dynamics can be explained by just two shocks that align with standard aggregate demand and aggregate supply disturbances. Responses to these shocks are found to be highly synchronized across major member states, consistent with a shared underlying euro area cycle. Using 156 quarterly time series covering 1985 Q1 to 2019 Q4 and a Common Component Structural VAR with frequency-domain identification, the authors report that two shocks explain the majority of business-cycle variance across key macro variables. The first shock behaves like an inflationary demand shock with output and inflation moving together and limited long-run effects on real activity, while the second behaves like a supply shock with inflation and output moving in opposite directions and a stronger link to longer-run variation. Extending the dataset through 2023 Q4 to examine the post-pandemic inflation surge, the historical decomposition indicates supply-side shocks dominated the initial rise in inflation through mid-2022, with demand-side pressures intensifying from mid-2022 and remaining an important source of inflation pressure through 2023. The paper is published to elicit comments and does not represent Bank of England policy.
Bank of England 2025-04-25
Bank of England staff paper finds two demand and supply shocks drive the euro area business cycle and recent inflation dynamics
The Bank of England released a staff working paper modeling euro area business cycle fluctuations, identifying two primary shocks—demand and supply—that explain most cyclical dynamics. Using data from 1985 to 2023, the study finds synchronized responses across major member states, with supply-side shocks initially driving post-pandemic inflation and demand-side pressures intensifying from mid-2022. The paper aims to elicit comments and does not reflect official Bank of England policy.