Adverse supply side shock

An adverse supply side shock is an event that causes an unexpected increase in costs or disruption to production. This will cause the short-run aggregate supply curve to shift to the left, leading to higher inflation and lower output.

Diagram showing supply-side shock

SRAS-shift-left

SRAS shifting to the left causes a higher price level and lower real GDP.

Causes of adverse supply side shocks

opec-cartel-oil-price-1970s

  1. Rising oil prices e.g. cartel activity by OPEC restricting supply and pushing up prices.
  2. Bad weather – Hurricane Katrina disrupted supply in the US.
  3. Declining productivity, e.g. general strikes
  4. Wage-push inflation. The 1970s were generally a period of rising wages, leading to cost-push inflationary pressures.
  5. Devaluation/depreciation in the exchange rate. A depreciation in the exchange rate causes import prices to rise and this can lead to inflation. A rapid devaluation can cause a significant increase in inflation.

Pound-dollar-daily-since-2006

Pound depreciated in 2008/09 and after Brexit vote June 2016,

Cost-push inflation

A consequence of a supply side shock is cost-push inflation. This causes higher inflation due to AS shifting to left.

UK inflation- 2017

Cost-push inflation in the UK. In 2008, rising oil prices contributed to higher inflation. In 2012, cost-push inflation was due to effects of depreciation in the exchange rate, higher taxes and

More on cost-push inflation

Response to supply-side shock

The difficulty of a supply side shock is that conventional monetary policy cannot deal with both higher inflation and lower real GDP at the same time.

For example, in 2009 and 2012, with cost-push inflation, the Bank of England kept interest rates very low at 0.5% – because they were more worried about fall in GDP than the rise in inflation.

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