Questions: Supply Shocks and Their Aggregate Effects

Question 1

A large oil price spike shifts the short-run AS curve leftward. The central bank responds with expansionary monetary policy to restore output to its original level. What is the most likely result?

• A. Output and price level both return to their pre-shock levels
• B. Output recovers, but the price level rises even further above its post-shock level
• C. The price level falls back to normal while output partially recovers
• D. Both output and inflation worsen because monetary policy is ineffective against supply shocks

Answer: (B)

Expansionary monetary policy shifts the AD curve rightward. Starting from the new post-shock equilibrium (higher prices, lower output), rightward AD raises output back toward potential — but it also pushes the price level higher still, compounding the inflationary effect of the supply shock. The policy can restore output or fight inflation, but not both simultaneously. This is the supply-shock policy dilemma: demand-management tools move along the new, less-favorable AS curve rather than restoring the old one.

Question 2

Which of the following best distinguishes the policy challenge posed by a negative supply shock from that posed by a negative demand shock?

• A. Supply shocks are temporary while demand shocks are permanent, so supply shocks require no policy response
• B. A negative demand shock reduces both output and the price level, so stimulating demand restores both; a negative supply shock raises prices while reducing output, so stimulating demand worsens inflation even as it helps output
• C. Supply shocks affect only the goods sector while demand shocks affect the money market
• D. Both types of shock require the same contractionary response — reducing money supply to control prices

Answer: (B)

With a negative demand shock, the economy moves to lower output and lower prices. Expansionary policy shifts AD rightward, moving back toward both original targets simultaneously. With a negative supply shock, the new equilibrium has higher prices AND lower output (stagflation). Stimulating demand fights the recession but worsens the inflation; contracting demand fights inflation but deepens the recession. There is no demand-management policy that can fix both simultaneously because the problem is the AS curve itself, not the AD curve.

Question 3

A positive supply shock — such as a major productivity improvement — can simultaneously lower the price level and increase real output.

• T. True
• F. False

Answer: True

A positive supply shock shifts the short-run AS curve rightward: at every price level, firms can now produce more. The new equilibrium with the same AD curve sits at higher output and a lower price level — the macroeconomic analog of a 'free lunch.' The U.S. productivity surge of the mid-1990s is the canonical example: rapid output growth with low inflation. This is why supply-side policies that genuinely raise productive capacity are macroeconomically valuable — they shift the AS curve rather than just stimulating demand.

Question 4

If a central bank reacts to a negative supply shock by contracting demand enough to fully offset the resulting inflation, unemployment will return to its pre-shock level.

• T. True
• F. False

Answer: False

Contracting demand (shifting AD leftward) does fight the inflation from the supply shock — it moves the equilibrium to a lower price level. But this comes at the cost of further reducing output and raising unemployment. Contractionary policy moves along the new (unfavorable) AS curve to a point with lower prices but even lower output than the initial post-shock equilibrium. To return unemployment to pre-shock levels, you would need expansionary policy — which worsens inflation. The supply shock has moved the AS curve, and no demand-management policy can undo that shift.

Question 5

Explain why a negative supply shock creates a policy dilemma that a negative demand shock does not.

Model answer: A negative demand shock shifts AD leftward, producing lower output AND lower prices. Expansionary policy shifts AD rightward, restoring both output and the price level toward their original values — the two policy goals move together. A negative supply shock shifts AS leftward, producing lower output AND higher prices simultaneously (stagflation). To restore output, you must stimulate demand — but that pushes prices even higher. To fight inflation, you must contract demand — but that deepens the recession. The two policy goals are now in direct conflict, and no combination of monetary and fiscal policy can restore both simultaneously. Policymakers must choose which problem to prioritize.

The key is understanding that demand-management tools only move the AD curve. With a favorable AS position, AD adjustment can hit both targets. With an unfavorable AS position, you are constrained to points on the new, less-productive supply curve. The only true solution to a negative supply shock is policies that shift AS back rightward — reducing energy costs, improving technology, removing supply bottlenecks — which lie mostly outside conventional monetary and fiscal policy tools.