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Supply Shocks & the Stagflation Dilemma

You’ll be able to

A negative supply shock moves output and prices in opposite directions

A negative supply shock — an oil price spike, a crop failure, a disrupted supply chain — raises production costs and shifts SRAS left. Output falls and the price level rises simultaneously. This is the only common scenario where those two move opposite ways, and that signature is how you identify a supply shock from a description without being told.

Reading the direction of a shock
AD shift → output and price level move the SAME way · SRAS shift → output and price level move OPPOSITE ways
Given what happened to output and prices, this identifies which curve moved. The single most useful diagnostic in Unit 3.

Why stagflation has no demand-side answer

Stagflation is falling output alongside rising prices. Demand-side policy can only shift AD, and shifting AD moves both variables the same direction — so it can fix one problem only by worsening the other. Expansionary policy raises output and pushes prices higher; contractionary policy lowers prices and pushes output lower. There is no AD shift that solves both, which is exactly the dilemma. The only real answer is supply-side: policies that lower costs or raise productivity and shift SRAS back right, which take time to work.

Two inflations with the same name

Demand-pull inflation comes from AD shifting right — "too much money chasing too few goods" — and it arrives with rising output, so it is the comparatively comfortable kind. Cost-push inflation comes from SRAS shifting left and arrives with falling output. The distinction is not academic: demand-pull calls for contractionary policy, which works; cost-push does not have a clean demand-side remedy at all.

Worked example

A drought sharply raises food and input prices in an economy at potential. Trace the short-run effect, then evaluate expansionary monetary policy as a response.

  1. 1.Higher input costs shift SRAS left.
  2. 2.Output falls below potential and the price level rises — stagflation.
  3. 3.Expansionary monetary policy would shift AD right, restoring output toward potential.
  4. 4.But that raises the price level further, worsening the inflation.
Answer: The drought produces stagflation. Expansionary policy can restore output but only at the cost of still higher inflation — the classic trade-off. Supply-side measures that lower costs are the only response that improves both, and they act slowly.
Watch out

A supply shock does not shift LRAS unless it destroys productive capacity. A temporary oil price spike shifts SRAS alone. A war that destroys factories shifts both. Read whether the shock is to costs or to capacity.

Checkpoint

Real GDP falls while the price level rises. The most likely cause is:

Checkpoint

Why is stagflation difficult for demand-side policy to address?

Checkpoint

Rapid growth in consumer and business spending pushes an economy past potential output, raising prices. This is:

On the exam

If a free response gives you the direction of both output and the price level and asks what happened, apply the same-way/opposite-way test before drawing anything. It identifies the curve in one step.

Answer the 3 checkpoints as you read.

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