This paper aims to decomposing output and inflation into supply and demand
components by applying Blanchard and Quah’s(1989) bivariate SVAR approach
to the output growth and inflation rate. Here, the supply and demand
components are defined by the output or inflation fluctuations due to supply
and demand shocks that have, respectively, permanent and temporary effects
on output. The results suggest that the output fluctuation due to demand
shocks, or the output gap estimated by SVAR, turns out to be closely
associated with the business cycle in Korea and has predictive content for
future inflation rate as well. While the supply component in inflation appears
to be on the rise in a recession period, the demand component in inflation is
more persistent and tends to move procyclically. Hence the policy authorities
need to be more alert to the demand-driven inflation.