Adverse Supply Shock and the Stagflation Dilemma

Adverse Supply Shock and the Stagflation Dilemma, step by step

1. 1

   Long-run equilibrium

   The economy begins in long-run equilibrium, where AD and SRAS meet on the LRAS curve. Real GDP is at full employment and the price level is stable.

2. 2

   Costs spike, SRAS shifts left

   A shock such as a sharp jump in oil prices raises production costs across the economy, so short-run aggregate supply shifts left. The price level rises and real GDP falls at the same time.

3. 3

   Stagflation appears

   The economy now suffers from stagflation, meaning higher inflation and higher unemployment together. This is the worst of both worlds and it is why supply shocks are so damaging.

4. 4

   The policy dilemma

   Demand-side policy cannot fix both problems at once. Using stimulus to shift AD right would restore output but push the price level even higher, while tightening to fight inflation would shift AD left and deepen the recession. There is no clean fix.

5. 5

   Slow self-correction

   If policymakers do nothing, the recession eventually forces nominal wages and input costs back down, shifting SRAS right and returning output to full employment. The adjustment is slow and painful, which is the cost of waiting it out.

Where it ends up

An adverse supply shock leaves the price level higher and real GDP lower at the same time, which is stagflation.

Now draw it yourself

Same graph, graded on whether you move the right curve and leave the rest alone.

• Expansionary Fiscal Policy →
• Consumer Confidence Shock →
• Oil Price Shock →

More AD-AS Model walkthroughs

• Negative Demand Shock and Long-Run Self-Correction →
• Positive Demand Shock and Long-Run Self-Correction →