An oil shock brings stagflation

The chain in words

1. Step 1

   Before the shock

   The economy sits at potential output. The horizontal axis is real GDP and the vertical axis is the price level. E₀ is on LRAS.

2. Step 2

   Short-run aggregate supply shifts left

   Oil is an input for almost everything. Higher oil prices raise the cost of producing any level of output, so short-run aggregate supply shifts left. Firms pass costs on and cut back. The economy moves to E₁: a higher price level and lower output, both at once.

3. Step 3

   The policy dilemma

   Rising prices with falling output is stagflation, and it traps policymakers. Boosting AD would restore output but push prices even higher. Cutting AD would tame prices but deepen the recession.

4. Step 4

   Costs ease, SRAS returns

   Most central banks wait. As oil prices ease and workers accept lower real wages, costs fall and SRAS returns to its old position. The economy comes back to E₀ on LRAS.

Takeaway. A negative supply shock raises the price level and cuts output at the same time, and demand policy cannot fix both.

Draw it yourself

More on the aggregate demand and aggregate supply graph