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 shifting to the left causes a higher price level and lower real GDP.
Causes of adverse supply side shocks
- Rising oil prices e.g. cartel activity by OPEC restricting supply and pushing up prices.
- Bad weather – Hurricane Katrina disrupted supply in the US.
- Declining productivity, e.g. general strikes
- Wage-push inflation. The 1970s were generally a period of rising wages, leading to cost-push inflationary pressures.
- 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 depreciated in 2008/09 and after Brexit vote June 2016,
A consequence of a supply side shock is cost-push inflation. This causes higher inflation due to AS shifting to left.
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.