Baumol, William J., and Alan S. Blinder. Economics: Principles and Policy, 7th ed. Orlando, FL: The Dryden Press, 1997, pp.628-642.

THE AGGREGATE SUPPLY CURVE

In earlier chapters we noted that aggregate demand is a schedule, not a fixed number. The quantity of real GDP that will be demanded depends on the price level, as summarized in the economy's aggregate demand curve.

Analogously, the concept of aggregate supply does not refer to a fixed number, but rather to a schedule (a supply curve). The volume of goods and services that profit-seeking enterprises will provide depends on the prices they obtain for their outputs, on wages and other production costs, on the state of technology, and on other things. The relationship between the price level and the quantity of real GDP supplied, holding all other determinants of quantity supplied constant, is called the economy's aggregate supply curve.

A typical aggregate supply curve is drawn in  Figure 27-1. It slopes upward, meaning that as prices rise more output is produced, other things held constant. It is not difficult to understand why. Producers in the U.S. economy are motivated mainly by profit. The profit made by producing a unit of output is simply the difference between the price at which it is sold and the unit cost of production:

Profit per unit = Price - Cost per unit

So, the response of output to a rising price level--which is what the slope of the aggregate supply curve shows--depends on the response of costs.

Many of the prices that firms pay for labor and other inputs are relatively fixed for periods of time--though certainly not forever. Often, workers and firms enter into long-term labor contracts that set money wages up to 3 years in advance. Even where there are no explicit contracts, wage rates typically adjust only once a year. During the interim period, money wages are fixed. Similarly, a variety of material inputs are delivered to firms under long-term contracts at prearranged prices.

Why is it significant that firms often purchase inputs at prices that stay fixed for considerable periods of time? Because firms decide how much to produce by comparing their selling prices with their costs of production; and production costs depend, among other things, on input prices. If the selling prices of the firm's products rise while its wages and other factor costs are fixed, production becomes more profitable, and firms will presumably increase output.

A simple example will illustrate the idea. Suppose a firm uses I hour of labor to manufacture a gadget that sells for $9. If workers earn $8 per hour, and the firm has no other production costs, its profit per unit is:

Profit per unit = Price - Cost per unit
= $9 - $8 = $1

Now what happens if the price of a gadget rises to $10, but wage rates remain constant? The firm's profit per unit becomes:

Profit per unit = Price - Cost per unit
= $10 - $8 = $2

With production more profitable, the firm will likely supply more gadgets.

The same process operates in reverse. If selling prices fall while input costs are relatively fixed, profit margins will be squeezed and production cut back. This behavior is summarized by the upward slope of the aggregate supply curve: Production rises when the price level (henceforth, P) rises, and falls when P falls. In other words:

The aggregate supply curve slopes upward because firms normally can purchase labor and other inputs at prices which are fixed for some period of time. Thus, higher selling prices for output make production more attractive.1

The phrase "for some period of time" alerts us to an important fact: The aggregate supply curve may not stand still for long. If wages or prices of other inputs change, as they surely will during inflationary times, then the aggregate supply curve will shift.

SHIFTS OF THE AGGREGATE SUPPLY CURVE

We have concluded so far that, for given levels of wages and other input prices, there will be an upward-sloping aggregate supply curve relating the price level to aggregate quantity supplied. Now let us consider what happens when these input prices change.

THE MONEY WAGE RATE

The most obvious determinant of the position of the aggregate supply curve is the money wage rate. Wages are the major element of cost in the economy, accounting for more than 70 percent of all inputs. Since higher wage rates mean higher costs, they spell lower profits at any given prices. That is why companies like American Airlines and Caterpillar have staged fierce battles with their unions in recent years in an effort to reduce wages.

Returning to our example, consider what would happen to a gadget producer if the money wage rose to $8.75 per hour while the price of a gadget remained $9. Profit per unit would decline from:

$9 - $8 = $1

to

$9.00 - $8.75 = $0.25

With profits squeezed, the firm would probably cut back on production.

This is the way firms in our economy typically react to a rise in wages. Therefore, a wage increase leads to a decrease in aggregate quantity supplied at current prices. Graphically, the aggregate supply curve shifts to the left (or inward), as shown in Figure 27-2. In this diagram, firms are willing to supply $6,000 billion in goods and services at a price level of 100 when wages are low (point A). But after wages increase these same firms are willing to supply only $5,500 billion at this price level (point B). By similar reasoning, the aggregate supply curve will shift to the right (or outward) if wages fall. Thus:

A rise in the money wage rate makes the aggregate supply curve shift inward, meaning that the quantity supplied at any price level declines. A fall in the money wage rate makes the aggregate supply curve shift outward, meaning that the quantity supplied at any price level increases.

PRICES OF OTHER INPUTS

In this regard, there is nothing special about wages. An increase in the price of any input that firms buy will shift the aggregate supply curve in the same way; that is:

The aggregate supply curve is shifted inward by an increase in the price of any input to the production process, and it is shifted outward by any decrease.

While there are many inputs other than labor, the one that has attracted the most attention in recent decades is energy. Increases in the price of energy, such as those that took place in the early 1980s and again during the 1990 Gulf war, push the aggregate supply curve inward more or less as shown in Figure 27-2. By the same token, a rise in the price of any input we import from abroad would have the effect shown in the figure.

TECHNOLOGY AND PRODUCTIVITY

Another factor that determines the position of the aggregate supply curve is the state of technology. Suppose, for example, that a technological breakthrough increases the productivity of labor, that is, output per hour of work. If wages do not change, such an improvement in productivity will decrease business costs, improve profitability, and encourage more production.

Once again, our gadget company will help us understand how this works. Suppose the price of a gadget stays at $9 and the hourly wage rate stays at $8, but gadget workers become much more productive. Specifically, suppose the labor input required to manufacture a gadget falls from 1 hour (which costs $8) to three-quarters of an hour (which costs $6). Then profit per unit rises from

$9 - $8 = $1

to

$9 - $6 = $3

The lure of higher profits should induce gadget manufacturers to increase production--which is, of course, why manufacturers are constantly striving to raise productivity. In brief, we have concluded that:

Improvements in productivity shift the aggregate supply curve outward.

Figure 27-2 can therefore be viewed as applying to a decline in productivity. Since the 1970s, slow growth of productivity has been a persistent problem for the U.S. economy, one that we will examine in depth in Chapter 37.

AVAILABLE SUPPLIES OF LABOR AND CAPITAL

The last determinant of the position of the aggregate supply curve is obvious. The bigger the economy--as measured by its available supplies of labor and capital--the more it is capable of producing. So:

As the labor force grows or improves in quality, and as the capital stock is increased by investment, the aggregate supply curve shifts outward to the right, meaning that more output can be produced at any given price level.

This last aspect of the aggregate supply curve is central to the political debate over alternative supply-side strategies. Although neither party excludes the other factor of production, Republicans tend to concentrate on augmenting the supply of capital while Democrats tend to emphasize improvements in labor quality.

These, then, are the major "other things" that we hold constant when drawing up an aggregate supply curve: wage rates, prices of other inputs (such as energy), technology, labor force, and capital stock. While a change in the price level moves the economy along a given supply curve, a change in any of the other determinants of aggregate quantity supplied shifts the entire supply schedule.

EQUILIBRIUM OF AGGREGATE DEMAND AND SUPPLY

Chapter 25 taught us that the price level is a crucial determinant of whether equilibrium GDP is below full employment (a "recessionary gap"), precisely at full employment, or above full employment (an "inflationary gap"). We are now in a position to analyze which type of gap, if any, will actually occur in any particular case. By combining the analysis of aggregate supply just completed with the analysis of aggregate demand from the last two chapters, we can determine simultaneously the equilibrium level of real GDP (Y) and the equilibrium price level (P).

Figure 27-3 displays the mechanics. Aggregate demand curve DD and aggregate supply curve SS intersect at point E, where real GDP is $6,000 billion and the price level is 100. As can be seen in the graph, at any higher price level, such as 120, aggregate quantity supplied would exceed aggregate quantity demanded. There would be a glut on the market as firms found themselves unable to sell all their output. As inventories piled up, firms would compete more vigorously for the available customers, thereby forcing prices down. Both the price level and production would fall.

At any price level lower than 100, such as 80, quantity demanded would exceed quantity supplied. There would be a shortage of goods on the market. With inventories disappearing and customers knocking on their doors, firms would be encouraged to raise prices. The price level would rise, and so would output. Only when the price level is 100 are the quantities of real GDP demanded and supplied equal. Therefore, only the combination of P = 100, Y = $6,000 is an equilibrium.

Table 27-1 illustrates the same conclusion in another way, using a tabular analysis similar to that of Chapter 25 (refer back to Table 25-2, page 597). Columns 1 and 2 constitute an aggregate demand schedule corresponding to the aggregate demand curve DD in Figure 27-3. Columns 1 and 3 constitute an aggregate sup. ply schedule corresponding exactly to aggregate supply curve SS in the figure.

It is clear from the table that equilibrium occurs only at P = 100 and Y = $6,000. At any other price level, aggregate quantities supplied and demanded would be unequal, with consequent upward or downward pressure on prices. For example, at a price level of 90, customers demand $6,200 billion worth of goods and services, but firms wish to provide only $5,800 billion. The price level is too low and will be forced upward. Conversely, at a price level of, say, 110, quantity supplied ($6,200 billion) exceeds quantity demanded ($5,800 billion), implying that the price level must fall.

RECESSIONARY AND INFLATIONARY GAPS REVISITED

Let us now reconsider a question we posed, but could not answer, in Chapter 25: Will equilibrium occur at, below, or beyond full employment?

We could not give a complete answer to this question in Chapter 25 because we had no way to determine the equilibrium price level, and therefore no way to tell which type of gap, if any, would arise. The aggregate supply and demand analysis summarized in Figure 27-3 now gives us what we need. But we fir that our answer is the same as it was in Chapter 25--anything can happen.

The reason is that nothing in Figure 27-3 tells us where full employment is; could be above the $6,000 billion equilibrium level or below it. Depending ( the locations of the aggregate demand and aggregate supply curves, then, v can reach equilibrium above full employment (an inflationary gap), at fl employment, or below full employment (a recessionary gap). In the short run with wages and other input costs fixed, that is all there is to it.

All three possibilities are illustrated in Figure 27-4. The three upper panels a familiar from Chapter 25. As we move from left to right, the expenditure schedule rises from C + Io + G + (X - IM) to C +I1 + G + (X - IM) to C +I2 + G + (X - IM), leading respectively to a recessionary gap, an equilibrium at full employment, and an inflationary gap. In fact, the upper left-hand diagram looks just like Figure 25-6 (page 601), and the upper right-hand diagram duplicates Figure 25-7 (page 602). We emphasized in Chapter 25 that any one of the three cases is possible, depending on the price level and the expenditure schedule.

In the three lower panels, the equilibrium price level is determined at poi E by the intersection of the aggregate supply curve (SS) and the aggregate demand curve (DD). But the same three possibilities emerge.

In the lower left-hand panel, aggregate demand is too low to provide jobs f the entire labor force, so there is a recessionary gap equal to distance EB, $1,000 billion. This corresponds precisely to the situation depicted on the income expenditure diagram immediately above it.

In the lower right-hand panel, aggregate demand is so high that the economy reaches an equilibrium well beyond full employment. There is an inflationary gap equal to BE, or $1,000 billion, just as in the diagram immediately above it.

In the lower middle panel, the aggregate demand curve D1D1 is at just the right level to produce an equilibrium at full employment. There is neither inflationary nor a recessionary gap, as in the diagram just above it.

It may seem, therefore, that we have done nothing but restate our previous conclusions. But, in fact, we have done much more. Because now that we ha' studied the determination of the equilibrium price level, we are able to examine how the economy adjusts to either a recessionary gap or an inflationary gap. Specifically, since wages are fixed in the short run, any one of the three cases depicted in Figure 27-4 can occur. But, in the long run, wages will adjust to lab market conditions. It is to that adjustment that we now turn.

ADJUSTING TO A RECESSlONARY GAP: DEFLATION OR UNEMPLOYMENT?

Suppose the economy starts with a recessionary gap--that is, an equilibrium below full employment--as in the lower left-hand panel of Figure 27-4. This might be caused, for example, by inadequate consumer spending or by anemic investment spending. What happens next?

With equilibrium GDP below potential, jobs will be hard to find. The ran of the unemployed will exceed the number expected to be jobless because moving, changing occupations, and so on. In the terminology of Chapter 23, there will be a considerable amount of cyclical unemployment. Businesses, on the other hand, will have little trouble finding workers. And their current employees will be eager to hang on to their jobs.

In such an environment, it will be very difficult for workers to win wage increases. Indeed, in extreme situations, wages may even fall--thus shifting the aggregate supply curve outward. (Remember, an aggregate supply curve is drawn for a given money wage.) But as the aggregate supply curve shifts outward--eventually moving from SoSo to S1S1 in Figure 27-5--prices decline and the recessionary gap shrinks. This is the process by which deflation erodes the recessionary gap, eventually leading the economy to an equilibrium at full employment (point F in Figure 27-5).

But there is an important catch. In our modern economy, this adjustment process proceeds slowly--painfully slowly. Our brief review of the historical record in Chapter 22 showed that the history of the United States includes several examples of deflation before World War II but none since. Not even the severe recession of 1981-1982, during which unemployment climbed above 10 percent, was able to force average prices and wages down--though it certainly slowed their rates of increase. Similarly, the recession of the early 1990s reduced inflation, but certainly did not bring deflation.

Exactly why wages and prices rarely fall in our modern economy has been a subject of intense and continuing controversy among economists for years. Some economists emphasize institutional factors like minimum wage laws, union contracts, and a variety of government regulations that place legal floors under particular wages and prices. Because most of these institutions are of relatively recent vintage, this theory successfully explains why wages and prices fall less frequently now than they did before World War II. However, only a small minority of the U.S. economy is subject to legal restraints on wage and price cutting. So it seems doubtful that legal restrictions can provide a complete explanation.

Other observers suggest that workers have a profound psychological resistance to accepting a wage reduction. This theory certainly has the ring of truth. Think how you would react if your boss announced he was cutting your hourly wage rate. You might quit, or you might devote less care to your job. If the boss suspects you will react this way, he may be reluctant to cut your wage. Nowadays, genuine wage reductions are rare enough to be newsworthy. United Airlines was one of the few firms that managed to cut wages; workers accepted an average 15 percent pay cut shortly after a 1994 employee buyout of the company. Many other companies have tried, but failed, to win similar concessions from their workers.

While no one doubts that wage cuts can be bad for morale, the psychological theory has one major drawback. It fails to explain why the psychological resistance to wage cuts apparently started only after World War II. Until a satisfactory answer to this question is provided, many economists will remain skeptical.

A third explanation is based on a fact we emphasized in Chapter 22--that business cycles were less severe in the postwar period than they were in the prewar period. Because workers and firms came to believe that recessions would not turn into depressions, the argument goes, they may have decided to wait out the bad times rather than accept wage or price reductions that they would later regret.

Yet another theory is .based on the old adage, "you get what you pay for." The idea is that workers differ in productivity, but that productivities of individual employees are hard to identify. Firms therefore worry that a general wage reduction will result in the loss of their best employees--since these workers have the best opportunities elsewhere in the economy. Rather than take this chance, the argument goes, firms prefer to maintain high wages even in recessions.

There are other theories as well, none of which commands a clear majority of professional opinion. But, regardless of the cause, we may as well accept the fact that, in our modern economy, prices and wages generally fall only sluggishly when demand is weak.

The implications of this rigidity are quite serious, for a recessionary gap cannot cure itself without some deflation. And if wages and prices will not fall, recessionary gaps like EB in Figure 27-5 will linger for a long time. That is:

When aggregate demand is low, the economy may get stuck with a recessionary gap for a long time. If wages and prices fall very slowly, the economy will endure a prolonged period of production below potential GDP.

DOES THE ECONOMY HAVE A SELF-CORRECTING MECHANISM?

Now a situation like this would, presumably, not last forever. As the recession lengthened, and perhaps deepened, more and more workers would be unable to find jobs at the prevailing high wages. Eventually, their need to be employed would overwhelm their resistance to wage cuts.

Firms, too, would become increasingly willing to cut prices as the period of weak demand persisted and managers became convinced that the slump was not merely a temporary aberration. Prices and wages did, in fact, fall during the Great Depression of the 1930s. And some fell again in the weak markets of the early 1990s.

However, nowadays political leaders of both parties believe it is folly to wait for falling wages and prices to eliminate a recessionary gap. They agree that some government action is both necessary and appropriate under recessionary conditions. But there is still vocal--and highly partisan--debate over how much and what kind of intervention is warranted. One reason for the disagreement is that the self-correcting mechanism does operate--if only weakly--to cure recessionary gaps.

AN EXAMPLE FROM RECENT HISTORY: DISINFLATION IN THE 1990s Recent history provides an excellent example. Recovery from the 1990-1991 recession was weak and long delayed, but it did eventually come. The unemployment rate peaked at 7.7 percent in June 1992 and then began a slow descent which brought it all the way down to 5.4 percent by December 1994. Meanwhile the inflation rate was falling from 6.1 percent in 1990 to 3.1 percent in 1991 and down to 2.7 percent in both 1993 and 1994. Qualitatively, this is just the sort of behavior the theoretical model of the self-correcting mechanism predicts. But it sure took a long time! Hence, the practical policy question is: How long can we afford to wait?

ADJUSTING TO AN INFLATIONARY GAP: INFLATION

Let us now consider what happens when the economy starts above full employment, that is, with an inflationary gap like that shown in Figure 27-6. As we shall see now, the tight labor market produces an inflation that eventually eliminates the gap, though perhaps in a slow and painful way. Let us see how.

When equilibrium GDP is above potential, jobs are plentiful and labor is in great demand. Firms are likely to be having trouble recruiting new workers, or even holding onto their old ones as other firms try to lure them away with higher wages. Such a situation arose in 1995 when the unemployment rate dropped to 5.4 percent. Businesses had to start paying higher wages because many kinds of workers were in short supply. (See the box on the next page.)

Rising wages add to business costs, thus shifting the aggregate supply curve inward. As the aggregate supply curve shifts in from SoSo to S1S1 in Figure 27-6 the size of the inflationary gap declines. In other words, inflation eventually erodes the inflationary gap and brings the economy to an equilibrium at full employment (point F).

There is a straightforward way of looking at the economics that underlies this process. Inflation arises because buyers are demanding more output than the economy is capable of producing at normal operating rates. To paraphrase an old cliche, there is too much demand chasing too little supply. Such an environment encourages price hikes.

But rising prices eat away at the purchasing power of consumers' wealth, forcing them to cut back on consumption, as explained in Chapter 24. In addition, exports fall and imports rise, as we learned in Chapter 25. Eventually, aggregate quantity demanded is scaled back to the economy's capacity to produce; and, at this point, the self-correcting process stops. That, in essence, is the unhappy process by which the economy cures itself of the excessive aggregate demand. In brief:

If aggregate demand is exceptionally high, the economy may reach a short-run equilibrium above full employment (an inflationary gap). When this occurs, the tight situation in the labor market soon forces wages to rise. Since rising wages increase business costs, prices increase; there is inflation. As higher prices cut into consumer purchasing power and net exports, the inflationary gap begins to close.

As the inflationary gap is closing, output falls and prices continue to rise; so the economy experiences stagflation until the gap is eliminated. At this point, a long-run equilibrium is established with a higher price level and with GDP equal to potential GDP.

Two caveats about this process should be mentioned. One we have already emphasized: The self-correcting mechanism takes time because wages and prices do not adjust quickly. An inflationary gap sows the seeds of its own destruction, but these seeds germinate slowly. So, once again, policymakers may want to speed up the process.

The other caveat is that the process works only in the absence of additional forces propelling the aggregate demand curve outward. But in the last chapter, we encountered several forces that might shift the aggregate demand curve outward. As you can see by manipulating the aggregate demand-aggregate supply diagram, if aggregate demand is shifting out at the same time that aggregate supply is shifting in, there will certainly be inflation, but the inflationary gap may not shrink. (Try this as an exercise, to make sure you understand how to use the apparatus.) So not all inflations come to a natural end.

DEMAND INFLATION AND STAGFLATION

Simple as it is, this adjustment model teaches us a number of important lessons about inflation in the real world. First, Figure 27-6 reminds us that the real culprit in this particular inflation is excessive aggregate demand--relative to potential GDE The aggregate demand curve is initially so high that it intersects the aggregate supply curve well beyond full employment. The resulting intense demand for goods and labor pushes prices and wages higher. While aggregate demand in excess of potential GDP is not the only possible cause of inflation, it certainly is the cause in our example.

However, business managers and journalists may blame inflation on rising wages. In a superficial sense, of course, they are right, because higher wages do indeed lead firms to raise their prices. But in a deeper sense they are wrong. Both rising wages and rising prices are symptoms of an underlying malady: too much aggregate demand. Blaming labor for inflation in such a case is a bit like blaming high doctor bills for making you ill.

Second, we see that output falls while prices rise as the economy adjusts from point E to point F in Figure 27-6. This is our first (but not our last!) explanation of the phenomenon of stagflation. Specifically:

A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand.

It is easy to understand why stagflation occurs in this case. When aggregate demand is excessive, the economy will temporarily produce beyond its normal capacity. Labor markets tighten and wages rise. Machinery and raw materials may also become scarce and so start rising in price. Faced by higher costs, the natural reaction of business firms is to produce less and to charge a higher price. That is stagflation.

TWO RECENT EXAMPLES

The stagflation that follows a period of excessive aggregate demand is, you will note, a rather benign form of the dreaded disease. After all, while output is falling, it nonetheless remains above potential GDP, and unemployment is low. The U.S. economy has experienced two such episodes in the last decade.

The more notable one came between 1988 and 1990. The long economic expansion of the 1980s brought the unemployment rate down to 5.5 percent by mid-1988 and (briefly) to a 15-year low of 5.0 percent by March 1989. Almost all economists believe that 5.0 percent is below the full-employment unemployment rate, that is, that the U.S. economy had an inflationary gap in 1989. As the theory suggests, inflation began to accelerate--from 4.4 percent in 1988 to 4.6 percent in 1989 and 6.1 percent in 1990.

In the meantime, the economy was stagnating. Real GDP growth fell from 3.5 percent during 1988 to 2.4 percent in 1989 and -0.2 percent in 1990. Inflation was eating away at the inflationary gap, which was virtually gone by mid-1990, when the recession started. Yet inflation remained high through the early months of the recession. The U.S. economy was in the stagflation phase.

A milder version of this same phenomenon occurred in the first half of 1995. After the unemployment rate fell to 5.4 percent in late 1994, slightly below the full-employment level, the U.S. economy slowed abruptly in the first half of 1995. But inflation during the first half of 1995 ran at a 3.2 percent annual rate, slightly above the 1994 rate of 2.7 percent. In both of these episodes, then, the U.S. economy behaved more or less as our simple model suggests.

Our overall conclusion about the economy's ability to right itself seems to run something like this:

The economy does indeed have a self-correcting mechanism that tends to eliminate either unemployment or inflation. However, this mechanism works slowly and unevenly. In addition, its beneficial effects on either inflation or unemployment are sometimes swamped by strong forces (such as rapid increases or decreases in aggregate demand) pushing in the opposite direction. Thus, the self-correcting mechanism cannot always be relied upon.

STAGFLATION FROM SUPPLY SHIFTS

We have just discussed the type of stagflation that follows in the aftermath of an inflationary boom. However, that is not what happened in the 1970s and early 1980s when unemployment and inflation soared at the same time. What caused this more virulent type of stagflation? Several things, but the principal villain was the rising price of energy.

In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of crude oil. American consumers soon found the prices of gasoline and home heating fuels increasing sharply, and American businesses found th_onne important cost of doing business--energy prices--rose drastically. wB struck again in 1979 to 1980, this time doubling the price of oil. Then the same thing happened a third time, albeit on a smaller scale, when Iraq invaded Kuwait in 1990.

Higher energy prices, we observed earlier, shift the economy's aggregate supply curve inward in the manner shown in Figure 27-2 (page 631). If the aggregate supply curve shifts inward, as it surely did in 1973 to 1974, 1979 to 1980, and 1990, production will decline. And in order to reduce demand to the available supply, prices will have to rise. The result is the worst of both worlds: falling production and rising prices.

This conclusion is shown graphically in Figure 27-7, which superimposes an aggregate demand curve, DD, on the two aggregate supply curves of Figure 27-2. The economy's equilibrium shifts upward to the left, from point E to point A. Thus, output falls while prices rise. In brief:

Stagflation is the typical result of adverse supply shifts.

The numbers used in Figure 27-7 are roughly indicative of what happened in the United States after the big "energy shock" of late 1973. Between 1973 (represented by supply curve SoSo and point E) and 1975 (represented by supply curve S1S1 and point A), real GDP fell by about 1 percent, while the price level rose a stunning 19 percent. Thus, inflation soared and the economy weakened. The general lesson to be learned from the U.S. experience with supply shocks is both clear and important:

The typical results of an adverse supply shock are a fall in output and an acceleration in inflation. This is one reason why the world economy was plagued by stagflation in the mid-1970s and early 1980s. And it can happen again if another series of supply-reducing events takes place.

Of course, supply shifts can work in the other direction as well. When the world oil market weakened in 1986, oil prices plummeted. And the price of oil tumbled again just after the Persian Gulf war. Both of these favorable supply shocks stimulated U.S. economic growth and curbed inflation. In fact the Consumer Price Index actually fell for a few months in 1986! The aggregate supply curve was shifting outward.

Favorable supply shocks tend to push output up and reduce inflation.


1. There are both differences and similarities between the aggregate supply curve and the microeconomic supply curves studied in Chapter 4. Both are based on the idea that quantity supplied depends on how output prices move relative to input prices. But the aggregate supply curve pertains to the behavior of the overall price level, whereas a microeconomic supply curve pertains to the price of some particular commodity.