After a major oil supply disruption, a central bank expands the money supply to combat the resulting recession. What happens to inflation?
AInflation falls — stimulus restores output, which lowers costs through economies of scale
BInflation worsens — expanding AD shifts the demand curve rightward against the already-shifted AS curve, raising the price level further
CInflation is unaffected — supply shocks isolate inflation from monetary policy entirely
DInflation and unemployment both fall because stimulus reverses the supply shock's effects
Expanding the money supply shifts AD rightward. But the AS curve has already shifted leftward from the supply shock. The new intersection of rightward-shifted AD and leftward-shifted AS sits at higher output than without stimulus (reducing unemployment) but at an even higher price level (worsening inflation). This is the policy trap: the standard tool for fighting recession exacerbates the inflation component of stagflation.
Question 2 Multiple Choice
Which best explains why stagflation is harder to address than a pure demand-driven recession?
AStagflation always persists longer, so standard tools run out of effectiveness over time
BCentral banks have no policy tools that affect supply-side conditions at all
CAny demand-management policy that alleviates unemployment worsens inflation, and vice versa — leaving no clean solution
DSupply shocks always produce more severe downturns than demand shocks of equivalent size
The defining difficulty of stagflation is the policy trap. Demand-management tools shift AD. Shifting it right helps unemployment but worsens inflation. Shifting it left reduces inflation but deepens the recession. With a pure demand shock, the problem and the solution involve the same direction of AD movement. With a supply shock, both problems exist simultaneously and any AD movement trades one problem for the other. The only genuine cure is restoring supply.
Question 3 True / False
A negative supply shock raises prices while simultaneously boosting output, creating a tradeoff policymakers can exploit.
TTrue
FFalse
Answer: False
A negative supply shock shifts AS leftward — firms can produce less at every price level. The new AS-AD intersection has a higher price level AND lower output simultaneously. This is stagflation, not a tradeoff to exploit. Tradeoffs between inflation and output arise from demand shocks (which move the economy along the AS curve). Supply shocks move the AS curve itself, producing the worst of both worlds.
Question 4 True / False
A positive supply shock — such as a major fall in commodity prices — simultaneously reduces inflation and increases output.
TTrue
FFalse
Answer: True
A positive supply shock shifts AS rightward. The new equilibrium has higher output AND a lower price level — the mirror image of stagflation. Both macroeconomic indicators improve at once. This is why productivity gains from technology are so valuable: they deliver the output expansion of stimulus without the inflationary cost.
Question 5 Short Answer
Why is a supply shock fundamentally different from a demand shock in terms of the policy response it requires?
Think about your answer, then reveal below.
Model answer: A demand shock moves the economy along the existing AS curve: a recession (leftward AD shift) can be countered by rightward AD stimulus, and vice versa — the problem and solution involve the same tool in opposite directions. A supply shock moves the AS curve itself, creating stagflation where output falls and prices rise simultaneously. Any demand-side response that fixes one variable worsens the other. The correct response requires restoring the supply side — reducing input costs, improving productivity, removing bottlenecks — not manipulating aggregate demand.
This asymmetry is why supply shocks historically caused so much policy confusion. Standard Keynesian or monetarist tools are demand-side instruments. When the 1970s oil shocks hit, policymakers tried both stimulus (which worsened inflation) and contraction (which worsened unemployment) before recognizing that demand management cannot cure a supply-side problem. Recognition of shock type is the first analytical step.