Lesson preview · Supply Shocks
Supply Shocks
~12 min · Free to read
In 1973, oil-producing nations cut their exports and the price of crude oil quadrupled. In 1979 it doubled again. Petrol queues snaked round the block, factories idled, and millions lost their jobs. Yet prices in the shops kept climbing the whole time.
That combination baffled the economists of the day. They knew demand shocks, where spending and prices rise and fall together. A slump was supposed to bring falling prices, not rising ones. Output down and prices up at the same time looked impossible. The supply side of the model is what explains it.
Key Term
Supply shock and stagflation — the two terms
A supply shock is a sudden change in firms’ production costs or productivity that shifts the short-run aggregate supply (SRAS) curve — the line showing how much output firms produce at each price level. It comes in two flavours:
- An adverse (negative) supply shock raises costs — an oil-price spike, a jump in wages, dearer raw materials, a broken supply chain. It shifts SRAS left: less output at every price level.
- A favourable (positive) supply shock lowers costs or raises productivity — cheaper energy, a technology gain. It shifts SRAS right: more output at every price level.
Stagflation is the painful result of an adverse supply shock: stagnant output (a slump, with rising unemployment) plus inflation (a rising price level) at the same time. The word splices “stagnation” and “inflation.”
Here is the move. An adverse supply shock shifts SRAS left. The aggregate-demand (AD) curve — total planned spending at each price level — does not move; it still slopes down. So the new short-run equilibrium slides up the fixed AD curve. Output falls while the price level rises. That is stagflation.
A favourable shock does the reverse. SRAS shifts right, the equilibrium slides down the AD curve, output rises and the price level falls. Either way the two move in opposite directions. That is the fingerprint of a supply shock — and the exact opposite of a demand shock, where output and prices move the same way.
That is the takeaway. Because the shock slides SRAS along a downward-sloping AD, output and the price level move in opposite directions. An adverse supply shock gives stagflation — and that opposite-direction signature is exactly how you tell a supply shock from a demand shock.
Trap · Common Misconception
"Inflation always means the economy is booming"
Rising prices feel like a sign of good times — lots of demand, busy shops, everyone spending. After a demand shock that is true: spending surges, output and prices climb together, jobs are plentiful.
An adverse supply shock breaks the link. Prices rise while output falls and unemployment climbs. The 1970s proved it: inflation in double digits alongside a deep slump. So inflation on its own tells you nothing about whether the economy is booming or sinking. You must ask what moved — demand (prices and output together) or supply (prices and output apart).
Check yourself · no marks
An economy sees output fall while the price level rises. Was this most likely a demand shock or a supply shock — and which direction did the relevant curve move?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
An economy starts at potential output, which we set to 100, with the price level also at 100. An oil-producing region then cuts exports and crude oil prices spike, raising costs across every industry. The new short-run equilibrium settles at output 92 and price level 108. (a) State the direction of real GDP, the price level, and unemployment. (b) Name the phenomenon. (c) Explain why this is harder for policymakers than a demand shock.
The history bears this out. The 1973 and 1979 oil crises were adverse shocks that gave the rich world its worst stagflation in a generation. A productivity boom or a lasting drop in energy costs is the favourable mirror image — output up, prices easing. And after 2021, tangled supply chains and port backlogs raised costs worldwide: another adverse shock, with output squeezed and prices climbing together.
Practice · 1 / 4
What is a supply shock?
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