Oil Shock: Stagflation Arrives

Oil Shock: Stagflation Arrives, step by step

1. 1

   Start at the natural rate

   The economy begins where the short-run Phillips curve crosses the vertical long-run Phillips curve, sitting at the natural rate of unemployment. Actual inflation equals expected inflation, so nobody is being surprised. The short-run curve you can see is the menu of inflation and unemployment combinations currently available.

2. 2

   Oil prices spike

   A supply disruption abroad doubles the price of crude oil. Energy is an input in almost every industry, so production and shipping costs jump across the whole economy at once. This is a cost-push shock rather than a demand shock, so the right question is not where the economy sits on the curve, but where the curve itself now lies.

3. 3

   SRPC shifts right

   Higher input costs mean firms raise prices by more at any given level of output and hiring, so the short-run Phillips curve shifts up and to the right. Read it off the axes: at the same unemployment rate, inflation is now higher, and getting back to the old inflation rate would require tolerating more unemployment. Every point on the menu got worse.

4. 4

   Stagflation appears

   The graph holds the plotted point at the natural rate, so what you can see is the whole menu getting worse. Where the economy actually lands depends on the demand side, and a cost shock typically also cuts output, so the point slides down and to the right along the NEW curve to higher unemployment as well. Both rising at once is stagflation, which a single fixed Phillips curve cannot produce, because moving along one curve trades inflation against unemployment in opposite directions. Only a shift of the whole curve explains it.

5. 5

   The long-run anchor has not moved

   The long-run Phillips curve stays where it was, because the natural rate of unemployment depends on the structure of the labor market and not on the price of a barrel of oil. Once energy costs stabilize or fall back, the short-run curve drifts back left on its own. If policymakers instead use stimulus to fight the higher unemployment, they lock in the higher inflation. That is the supply-shock policy dilemma.

Where it ends up

An adverse supply shock shifts the short-run Phillips curve up and to the right, so the economy faces higher inflation at every unemployment rate. Inflation and unemployment can rise together, which is stagflation, and the long-run Phillips curve does not move.

Now draw it yourself

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

• Global Commodity Glut →
• Productivity Breakthrough →
• Longer Jobless Benefits →

More Phillips Curve walkthroughs

• Expansionary Policy: Short Run vs Long Run →
• Falling Inflation Expectations →
• A Favorable Supply Shock →
• Structural Change Raises the Natural Rate →
• Credible Central Bank, Cheap Disinflation →