In 1973, OPEC quadrupled oil prices, raising production costs across nearly every industry. A student argues: 'higher costs reduced output, so firms had less to sell, which lowered prices as demand fell.' What is wrong with this reasoning?
ANothing — this is the correct description of a cost-driven price decline
BOil was not a significant enough input to affect the aggregate economy
CA negative supply shock shifts the SRAS curve left, raising the price level while reducing output — the opposite of the student's prediction
DThe student confused a demand-side shock with a supply-side shock, but both produce the same outcome
The student reversed the price direction. In the AS-AD model, a leftward shift of the short-run aggregate supply curve moves the equilibrium to a new intersection that is higher on the price axis (inflation) and lower on the output axis (recession). This is stagflation — simultaneous rising prices and falling output. The student's error is thinking that output declines lower prices; in a supply shock, the price level rises precisely because the supply schedule itself shifted inward, reflecting higher production costs at every output level.
Question 2 Multiple Choice
Why does a negative supply shock create a worse policy dilemma than a negative demand shock?
ASupply shocks are always larger in magnitude than demand shocks, making them harder to offset
BSupply shocks affect the financial sector directly, which demand policy cannot reach
CStimulating demand to fight the recession worsens inflation; tightening to fight inflation worsens the recession — no policy simultaneously restores both output and price stability
DSupply shocks affect the long-run aggregate supply curve, which monetary policy is powerless to shift
A demand shock moves output and prices in the same direction, so a single policy response can offset both: a negative demand shock lowers both output and prices, so expansionary policy restores both. A supply shock moves them in opposite directions (output falls, prices rise), creating a genuine dilemma. Tightening monetary policy shifts AD left — it counters inflation but deepens the recession. Easing shifts AD right — it supports output but validates higher prices. The central bank must choose between two evils rather than finding a clean fix.
Question 3 True / False
A central bank that responds to a negative supply shock by expanding money supply can simultaneously restore the original output level and the original price level.
TTrue
FFalse
Answer: False
This is the core policy dilemma of stagflation. When SRAS shifts left, the new equilibrium has lower output and higher prices. Accommodative monetary policy (expanding money supply) shifts AD right, which can restore output — but does so by validating and potentially entrenching the higher price level, risking further inflation. Tightening restores the price level at the cost of deeper recession. No single AD shift returns the economy to both the original output and original price simultaneously — that would require shifting SRAS back to its original position, which requires reversing the underlying cost shock.
Question 4 True / False
If workers expect prices to keep rising after a negative supply shock and demand higher nominal wages, this can trigger a wage-price spiral that shifts the SRAS curve further left.
TTrue
FFalse
Answer: True
Wage-price dynamics are a key amplifier of supply shocks. If a supply shock raises prices and workers respond by demanding higher nominal wages (to preserve real purchasing power), firms face even higher production costs — shifting SRAS left again. Higher prices → higher wage demands → higher costs → higher prices: a self-reinforcing spiral. This is exactly what worsened the 1970s stagflation. A central bank that credibly commits to fighting inflation can break this loop by anchoring expectations, preventing the secondary wage-price feedback even if it cannot avoid the initial output loss.
Question 5 Short Answer
Explain why a negative supply shock creates a policy dilemma that a negative demand shock does not.
Think about your answer, then reveal below.
Model answer: A negative demand shock moves output and prices in the same direction (both fall), so a single expansionary policy can address both simultaneously — boosting AD restores output and reverses the price decline. A negative supply shock moves them in opposite directions: output falls but prices rise (stagflation). Any policy response faces a trade-off. Expanding monetary policy (shifting AD right) supports output but pushes the already-elevated price level higher, risking entrenched inflation. Tightening (shifting AD left) reduces inflation but worsens the recession. There is no AD shift that cleanly returns both output and the price level to their pre-shock values.
The fundamental asymmetry is directional: demand shocks align the effects on output and prices, so policy can simultaneously counteract both. Supply shocks misalign them. The only way to fully reverse a supply shock without a policy dilemma is to reverse the underlying cost increase — which is outside the reach of conventional monetary or fiscal policy. This is why supply shocks like the 1973 oil embargo produced a decade of difficult tradeoffs between inflation and unemployment, culminating in the painful recession of the early 1980s needed to re-anchor expectations.