David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 21 Aggregate supply, prices and adjustment to shocks
A temporary supply shock
shifts the short-run aggregate
supply schedule, but leaves
potential output unaltered.
Monetary policy
accommodates a
temporary supply shock
when monetary policy is
altered to help stabilize output.
The consequence, however, is
higher inflation.
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A temporary supply shock
A temporary supply shock leaves potential output unaffected in the long run.
With the vertical AS schedule unaltered, the short-run supply curve must shift.
Although the SAS schedule is mainly influenced by inherited nominal wages, it is
also affected by other input prices. Suppose a temporary oil price rise makes firms
charge higher prices at any output level. Figure 21.10 shows a shift upwards in
short-run supply, from SAS to SAS'. The new short-run equilibrium is at E'.
Inflation rises but output and employment fall because the central bank raises real
interest rates in response to higher inflation.
If the central bank maintains its inflation target n*, lower output and employment
at E' gradually reduce inflation and nominal wage growth, shifting SAS' gradually back to SAS. The
economy slowly moves down the AD schedule back to the original equilibrium at E.
A different outcome is possible. When the higher oil price shifts SAS to SAS', it is possible to avoid the
period oflow output as the economy moves along AD from E' back to E. A change in monetary policy can
shift AD up enough to pass through E'. Output can quickly return to potential output, but only because the
inflation target 4 has been loosened from n* to n*". The new long-run new equilibrium is then at E".
A central bank caring a lot about output stability may accommodate short-run supply shocks, even if this
means higher inflation. A central bank caring more about its inflation target than about output stability
will not accommodate temporary supply shocks.
n*"
rt'
n * Y' y
Output
Higher oil prices force firms to raise prices. In the short run,
SAS shifts up to SAS', and equilibrium shifts from E to E'.
Higher inflation reduces aggregate demand since the central
bank raises real interest rates. Once the temporary supply
shock disappears, SAS' gradually falls back to SAS, and
equilibrium is eventually restored at E.
Figure 21.10 A temporary supply shock
y
It matters a lot whether the supply shock is temporary
or permanent. If potential output is permanently
affected, aggregate demand must eventually rise to
match. Once a supply side shock is diagnosed as
permanent, it should be accommodated.
Demand shocks
Figure 21.11 explores demand shocks not caused by
monetary policy. If demand is high, facing AD' the
economy moves along its short-run supply curve to
point A. If demand is low, facing AD" the economy
moves along the SAS curve to point B.
Suppose the central bank diagnoses that an
expansionary demand shock has occurred. It can
tighten monetary policy and shift AD' back down
to AD again. Similarly, it can loosen monetary
policy in response to low aggregate demand AD",
restoring AD again. The economy remains at E.
Both inflation and output are stabilized.
It is easy for the central bank to tell where inflation
is relative to its target rate. It is harder to estimate
the level of potential output, which can change over
time. This is part of the modern case for using
4 Looser monetary policy shifts the ii schedule to the right in Figure 21.1. However, once long-run equilibrium is restored i* must
be unaltered: since aggregate supply is eventually unaltered, aggregate demand cannot eventually change. The only way for the
central bank to loosen monetary policy without changing i* is to accept a higher inflation target n * .
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