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

supply shock
is an event that directly affects firms’ costs of production and thus
the prices they charge; it shifts the economy’s aggregate-supply curve and, as a re-
sult, the Phillips curve. For example, when an oil price increase raises the cost of
producing gasoline, heating oil, tires, and many other products, it reduces the
quantity of goods and services supplied at any given price level. As panel (a) of
Figure 33-8 shows, this reduction in supply is represented by the leftward shift in
the aggregate-supply curve from 
AS
1
to 
AS
2
. The price level rises from 
P
1
to 
P
2
, and
output falls from 
Y
1
to 
Y
2
. The combination of rising prices and falling output is
sometimes called 
stagflation.
s u p p l y s h o c k
an event that directly alters
firms’ costs and prices, shifting
the economy’s aggregate-supply
curve and thus the Phillips curve
Quantity
of Output
0
Price
Level
P
2
P
1
Aggregate
demand
(a) The Model of Aggregate Demand and Aggregate Supply 
Unemployment
Rate
0
Inflation
Rate
(b) The Phillips Curve
3. . . . and
raises 
the price 
level . . . 
B
A
AS
2
Aggregate
supply, 
AS
1
B
A
1. An adverse
shift in aggregate 
supply . . . 
2. . . . lowers output . . . 
4. . . . giving policymakers 
a less favorable tradeoff
between unemployment
and inflation.
Y
2
Y
1
PC
2
Phillips curve, 
PC
1
F i g u r e 3 3 - 8
A
N
A
DVERSE
S
HOCK TO
A
GGREGATE
S
UPPLY
.
Panel (a) shows the model of aggregate
demand and aggregate supply. When the aggregate-supply curve shifts to the left from
AS
1
to 
AS
2
, the equilibrium moves from point A to point B. Output falls from 
Y
1
to 
Y
2
, and
the price level rises from 
P
1
to 
P
2
. Panel (b) shows the short-run tradeoff between inflation
and unemployment. The adverse shift in aggregate supply moves the economy from a
point with lower unemployment and lower inflation (point A) to a point with higher
unemployment and higher inflation (point B). The short-run Phillips curve shifts to the
right from 
PC
1
to
PC
2
. Policymakers now face a worse tradeoff between inflation and
unemployment.

---

7 7 6
PA R T T W E LV E
S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
This shift in aggregate supply is associated with a similar shift in the short-run
Phillips curve, shown in panel (b). Because firms need fewer workers to produce
the smaller output, employment falls and unemployment rises. Because the price
level is higher, the inflation rate—the percentage change in the price level from the
previous year—is also higher. Thus, the shift in aggregate supply leads to higher
unemployment and higher inflation. The short-run tradeoff between inflation and
unemployment shifts to the right from 
PC
1
to 
PC
2
.
Confronted with an adverse shift in aggregate supply, policymakers face a dif-
ficult choice between fighting inflation and fighting unemployment. If they con-
tract aggregate demand to fight inflation, they will raise unemployment further. If
they expand aggregate demand to fight unemployment, they will raise inflation
further. In other words, policymakers face a less favorable tradeoff between infla-
tion and unemployment than they did before the shift in aggregate supply: They
have to live with a higher rate of inflation for a given rate of unemployment, a
higher rate of unemployment for a given rate of inflation, or some combination of
higher unemployment and higher inflation.
An important question is whether this adverse shift in the Phillips curve is
temporary or permanent. The answer depends on how people adjust their expec-
tations of inflation. If people view the rise in inflation due to the supply shock as a
temporary aberration, expected inflation does not change, and the Phillips curve
will soon revert to its former position. But if people believe the shock will lead to
a new era of higher inflation, then expected inflation rises, and the Phillips curve
remains at its new, less desirable position.
In the United States during the 1970s, expected inflation did rise substantially.
This rise in expected inflation is partly attributable to the decision of the Fed to
“Remember the good old days when all the economy needed was a little fine-tuning?”

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C H A P T E R 3 3
T H E S H O R T - R U N T R A D E O F F B E T W E E N I N F L AT I O N A N D U N E M P L O Y M E N T
7 7 7
accommodate the supply shock with higher money growth. (As we saw in Chap-
ter 31, policymakers are said to