Supply Shocks and Stagflation

During the 1970s, the industrial world was struck. by a new macroeconomic malady, supply shocks, a supply shock is a sudden change in input costs or productivity which shifts aggregate supply sharply. Supply shocks occurred with particular virulence in 1973. Called the-year of the seven plagues,” 1973 was marked by crop failures, shifting ocean currents, massive speculation on world commodity markets, turmoil in foreign exchange markets, and a Mideast war that led to quadrupling of the world price of crude oil.

How can we understand the combination of falling output and rising prices? This large, unexpected rise in the cost of raw materials constituted a supply shock, which we portray as an upward shift in the aggregate supply curve. An upward shift in AS indicates that businesses l supply the same level of output only at substantially higher prices. Figure 20-8 illustrates such a supply shift. Supply shocks produce higher prices, followed by a decline in output and an increase in unemployment. Supply shocks thus lead to a deterioration all the major goals of macroeconomic policy.

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