Home > Aggregate Supply, ASAD, Macro > Modelling a supply shock in the ASAD

Modelling a supply shock in the ASAD

You can use the ASAD to model the effect of a supply shock. The most common and relevant one to look at would be a rise in the price of oil as this is one that affects economies around the world pretty often.

The way to think about this is to think about the supply shock affecting the ‘mark-up’ in firms’ price setting decisions. If the price of oil rises, that will push firms’ costs up outside of labour costs. The mark-up, \mu, is not just a ‘profit’ mark-up, but captures the costs of other inputs as well.

Remember that a negative supply shock, which pushes up the profit mark-up, will cause the AS curve to shift up.

Lets see what’s going on here:
We’ve shifted from curve AS1 to AS2 which has pushed prices up from their original level (where prices were equal to expected prices, Pe), to the new price of P2. Output has fallen from the natural level of output Yn to Y2. So we have had prices going up and output going down in the short run.

It gets worse in the medium run. Remember that the starting medium run equilibrium was where prices equal expected prices. The shift of the AS curve has implied that if the supply shock is permanent, we will go to a new medium run equilibrium where prices equal expected prices at a new natural level of output, Yn’. Obviously if the supply shock is temporary, the AS curve will just shift back, but if it is permanent then firms will always face higher costs, so at any given level of prices, they will be able to produce less. This is what the shift of the AS curve has told us.

So this supply shock has meant higher prices, lower output, and if the shock is permanent, a new lower natural level of output for the economy. Supply shocks are generally bad news.

Now at this point the policy makers have a decision to make. Do they use expansionary fiscal or monetary policy, to try and increase output, or do they just leave things alone and see what happens.

If they don’t do anything, the AS curve will just keep on shifting upwards until it settles at the point where it intersects the AD curve at the new natural level of output, Yn’.

So we end up with a new expected price level, Pe=P3, where price expectations have caught up with prices, in a new medium run equilibrium, at the new natural level of output, Yn’.

Now what happens if the policy makers try to use an expansionary fiscal or monetary policy to counter the loss of output?

In the short run, this expansionary policy managed to limit the loss of output – notice how Y2 is closer to Yn in this diagram than the one above. But the price that they pay for that is that when the economy does settle at the new natural level of output, Yn’, the price level will be even higher than it was on the one above. So whilst the expansionary policy can help limit a collapse in output in the short run, when it comes to the medium run you will pay for it with higher prices. Of course there may be other reasons which motivate using an expansionary policy, you might reason that allowing output to collapse could cause permanent scars to the economy, leave a generation unemployed that will never get back into the economy, drive foreign investment out of the country and so on, which would mean your AS curve actually carried on shifting further to the left. But the basic analysis of the model is that expansionary policy would be a bad thing in terms of prices in the medium run.

What about if the policy makers actually used a contractionary policy?

This time the collapse in output in the short term is much sharper. But the eventual rise in prices by the time you get to the medium run is not as pronounced. So if you don’t mind compounding the problem of falling output in the short run by using a contractionary policy, you can get a lower price rise by the time you get to the medium run. In practice this sort of policy would not be politically very popular, but it works as a theoretical example in the model.

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Categories: Aggregate Supply, ASAD, Macro
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