Supply side shocks

A change in costs that shifts the aggregate supply (AS) curve. The level of national income can change in the short term if there is a supply-side shock. Many factors can bring about a sudden changes in supply, including changes in the following: 1. Wage levels, which affect firms unit labour costs. 2. Other costs of production, such as commodity prices, or which changes in oil prices are significant. 3. Indirect taxes, such as VAT. 4. Subsidies. 5. Productivity of factors, especially labour. 6. Changes in the use of technology and production methods. 7. Direct taxes, such as income tax, via an incentive or disincentive effect. 8. Length of the working week. 9. Labour migration.

The effect of cost shocks

A cost shock will affect the aggregate supply curve in the short run, and the AS curve will shifts upwards and to the left. Supply side shocks Taking the example of a wage shock, the increase in wages will lead to a rise in business costs, which will shift the AS curve shift upwards, causing the price level will rise from P to P1 and the equilibrium level falls from Y to Y1. This will cause a contraction of AD, and equilibrium will fall to Y1, resulting in a fall in real output and a probable loss of jobs. Therefore, cost shocks can result in serious economic difficulties for the affected country. Increases in oil prices are always a concern because of the general inflationary effects they can create.

Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate is low. Stagflation is the combination of recession with high inflation. The word stagflation is a conflation of stagnation and inflation. Possible causes of stagflation include short supplies of essential commodities and too fast a rise in money supply. Once stagflation occurs it is difficult to deal with. The measures a government would usually take to revive an economy in recession (cutting interest rates or increasing government spending) will also increase inflation. Under normal recessionary conditions inflationary policies are acceptable, but given already high inflation, pushing inflation still higher is itself damaging.

Macroeconomic equilibrium The interaction of aggregate demand and aggregate supply determines macroeconomic equilibrium, and understanding macroeconomic equilibrium provides insight into changes in real GDP and the price level. In considering determination of real GDP and the price level, however, we must distinguish between the short run and the long run. Short-run macroeconomic equilibrium occurs (geometrically) at the intersection of the short-run aggregate supply curve (SAS) and the aggregate demand curve (AD). This intersection indicates the price level at which the aggregate quantity of final goods and services supplied in the economy is equal to the aggregate quantity demanded, and indicates as well the corresponding level of real GDP.

To see that this point of intersection is an equilibrium point, consider first a situation where the price level is below that corresponding to the short-run equilibrium. At this price level, the quantity of real GDP that will be supplied by firms will be less than the quantity of real GDP that will be demanded by households, business firms, government, and net foreign demand. With firms unable to meet demand, inventories decline and back orders become the rule. In order to meet the strong demand, firms will begin to increase production; and in so doing will incur additional resource costs that will result in price increases (i.e., there will be a movement up along the SAS curve). As prices increase, this will lead to a moderating of demand (movement up along the AD curve). These movements will continue until quantity supplied equals quantity demanded -- at the point of intersection of the SAS and AD curves. Similarly, if the price level is greater than the equilibrium level, the quantity of real GDP supplied will exceed the quantity demanded. In this case, inventories will accumulate, goods and services will go unsold, and eventually firms will lay off workers, cut production, and reduce prices in order to sell theor output. This translates into a movement down along the SAS curve, and as prices fall there will be a corresponding movement down along the AD curve. These movements will continue until equilibrium is reached. Long-run macroeconomic equilibrium requires that real GDP be equal to potential GDP, and corresponds to a situation of full employment. That is, long-run macroeconomic equilibrium entails the economy being on its vertical long-run supply curve. This contrasts with the short-run equilibrium situation, in which real GDP may be less than or greater than (or equal to) potential GDP. Let's take a look at the different possible short-run situations vis--vis long-run equilibrium. Consider first the case where there is a short-run equilibrium at a real GDP below the level of potential GDP. This is called a below full-employment equilibrium, and the difference between potential GDP and real GDP is called a recessionary gap. Note that this situation may correspond to a recession, but this will not necessarily be the case: if potential GDP has grown faster than real GDP recently, a recessionary gap

may exist even with continued (slow) real GDP growth. In any case, the most obvious manifestation of a recessionary gap is the presence of high unemployment.

Short-run equilibrium at a real GDP in excess of potential GDP is called an above full-employment equilibrium. The excess of real GDP over potential GDP is called an inflationary gap. That is, this gap creates inflationary pressure. Unemployment in this situation would be below the full-employment level of unemployment.

The third possibility is with a short-run equilibrium at a real GDP just equal to potential GDP. This is a full-employment equilibrium, and is the only case where we have long-run equilibrium as well as short-run equilibrium.

Which of these three possibilities corresponds to the situation in which the U.S. economy presently may be found? Parkin notes that we experienced an inflationary gap in 1988-90, recessionary gaps in the early 80s and again in the early 90s, and he suggests that the economy was at full employment in mid-1994. What about now? Fluctuations in real GDP around its long-term upward trend (reflecting increases in potential GDP) may stem from either fluctuations in aggregate demand or in aggregate supply. First consider the consequences of an increase in aggregate demand, as might occur in response to increases in expected future incomes, profits, or inflation; in response to a lower exchange rate or higher foreign incomes; in response to fiscal policy increasing government spending or transfer payments, or decreasing taxes; or in response to expansionary monetary policy (increasing the money supply) or lowering of interest rates. Increased aggregate demand will result in a new short-run macroeconomic equilibrium, with a higher price level and a higher level of real GDP.

However, workers will now be receiving a lower real wage (since, by assumption, movements up along the SAS curve entail increases in output prices while wages and other factor prices remain constant), and profits of firms will have increased. In these circumstances, workers will seek wage increases and firms, eager to maintain employment and output levels, will grant such increases (without wage increases, firms risk losing workers). But increased wages will shift the short-run aggregate supply curve to the left. This shift will cause a movement up along the aggregate demand curve, raising the price level and reducing the level of real GDP.

Note that we're looking at secondary effects of the increase in AD, and it will take time for the secondary effects to develop.

Similarly, changes in SAS can result in fluctuations in real GDP around potential GDP . For example, as we've just seen, a leftward shift of the SAS curve (as would occur with an increase in factor prices) will bring about a new short-run macroeconomic equilibrium, with higher prices and lower real GDP than prior to the shift. Wage-Spiral Shocks A macroeconomic theory to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. The wage-price spiral suggests that rising wages increase disposable income, thus raising the demand for goods and causing prices to rise. Rising prices cause demand for higher wages, which leads to higher production costs and further upward pressure on prices. So "wages chase prices and prices chase wages," persisting even in the face of a (mild) recession. The Wage element of the price/wage spiral does not apply if markets are relatively competitive. The spiral is also weakened if labor productivity rises at a quick rate.