I n t h I s c h a p t e r y o u w I l L

stagflation.
What should policymakers do when faced with stagflation? As we will discuss
more fully later in this book, there are no easy choices. One possibility is to do
nothing. In this case, the output of goods and services remains depressed at 
Y
2
for
a while. Eventually, however, the recession will remedy itself as perceptions,
wages, and prices adjust to the higher production costs. A period of low output
and high unemployment, for instance, puts downward pressure on workers’
wages. Lower wages, in turn, increase the quantity of output supplied. Over time,
as the short-run aggregate-supply curve shifts back toward 
AS
1
, the price level
falls, and the quantity of output approaches its natural rate. In the long run, the
economy returns to point A, where the aggregate-demand curve crosses the long-
run aggregate-supply curve.
Alternatively, policymakers who control monetary and fiscal policy might
attempt to offset some of the effects of the shift in the short-run aggregate-supply
s t a g f l a t i o n
a period of falling output
and rising prices
Quantity of
Output
Price
Level
0
Aggregate demand
A
B
Y
1
Y
2
3. . . . and 
the price 
level to rise.
2. . . . causes output to fall . . .
1. An adverse shift in the short-
run aggregate-supply curve . . .
Short-run
aggregate
supply, 
AS
1
Long-run
aggregate
supply
P
2
P
1
AS
2
F i g u r e 3 1 - 1 0
A
N
A
DVERSE
S
HIFT IN
A
GGREGATE
S
UPPLY
.
When
some event increases firms’ costs,
the short-run aggregate-supply
curve shifts to the left from 
AS
1
to
AS
2
. The economy moves from
point A to point B. The result is
stagflation: Output falls from 
Y
1
to 
Y
2
, and the price level rises
from 
P
1
to 
P
2
.

---

C H A P T E R 3 1
A G G R E G AT E D E M A N D A N D A G G R E G AT E S U P P LY
7 2 7
C A S E S T U D Y
OIL AND THE ECONOMY
Some of the largest economic fluctuations in the U.S. economy since 1970 have
originated in the oil fields of the Middle East. Crude oil is a key input into the
production of many goods and services, and much of the world’s oil comes
from Saudi Arabia, Kuwait, and other Middle Eastern countries. When some
event (usually political in origin) reduces the supply of crude oil flowing from
this region, the price of oil rises around the world. U.S. firms that produce gaso-
line, tires, and many other products experience rising costs. The result is a left-
ward shift in the aggregate-supply curve, which in turn leads to stagflation.
curve by shifting the aggregate-demand curve. This possibility is shown in Fig-
ure 31-11. In this case, changes in policy shift the aggregate-demand curve to the
right from 
AD
1
to 
AD
2
—exactly enough to prevent the shift in aggregate supply
from affecting output. The economy moves directly from point A to point C. Out-
put remains at its natural rate, and the price level rises from 
P
1
to 
P
3
. In this case,
policymakers are said to 
accommodate
the shift in aggregate supply because they
allow the increase in costs to affect the level of prices permanently.
To sum up, this story about shifts in aggregate supply has two important
implications:
◆
Shifts in aggregate supply can cause stagflation—a combination of recession
(falling output) and inflation (rising prices).
◆
Policymakers who can influence aggregate demand cannot offset both of
these adverse effects simultaneously.
Quantity of
Output
Natural rate
of output
Price
Level
0
Short-run
aggregate
supply, 
AS
1
Long-run
aggregate
supply
Aggregate demand, 
AD
1
A
C
P
2
P
3
P
1
AS
2
3. . . . which
causes the
price level 
to rise 
further . . .
4. . . . but keeps output
at its natural rate.
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
1. When short-run aggregate
supply falls . . .
AD
2
F i g u r e 3 1 - 1 1
A
CCOMMODATING AN
A
DVERSE
S
HIFT IN
A
GGREGATE
S
UPPLY
.
Faced with an adverse shift in
aggregate supply from