The role of agregate demand and supply shocks in a low-income country : evidence from Bangladesh

This paper explores the relative role of aggregate demand and supply shocks in affecting the output level and inflation rate in a low-income country vulnerable to various economic shocks. The study uses Bangladesh data, and following Cover et al (2006), employs a modification of the Blanchard-Quah (BQ) approach, in which the two shocks are allowed to be correlated. Strong evidence is found for the hypothesis that aggregate demand and supply shocks are interrelated in Bangladesh. For the case in which causality is assumed to be running from demand to supply shocks, it was found that an independent supply shock plays significant role for fluctuations in inflation, which was absent in the standard BQ model. The results suggest that a tightening of monetary policy may lead to an adverse effect on the long-run growth potential and some supply-side policies may be required to supplement contractionary monetary policy in combating inflation in Bangladesh.