Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Bumping into Supply-Side Shocks

In many ways supply-side shocks are more important than those hitting the demand side (which we discuss in the earlier section ‘Delving into Demand-Side Shocks’). Demand-side shocks typically have only a temporary impact on the economy – usually the price level adjusts and the economy goes back to its natural level of output.

But supply-side shocks can have a permanent impact on the economy. Indeed, the only way for an economy to experience persistent growth is by increasing long-run aggregate supply (LRAS).

In this section we take a look at two important supply-side shocks: changes in energy prices and technological progress. Many other things can affect aggregate supply, and you can read about them in Chapter 6.

Examining the impact of energy prices

A fall in the energy price increases aggregate supply. Why? Well, energy is one of the basic inputs that firms use to produce goods and services, so the cheaper it is, the more easily firms can produce output. Low energy costs make turning factors of production, such as labour and capital, into goods and services, relatively easy.

Whether the impact on the economy is permanent or temporary depends, of course, on whether the fall in energy prices is permanent or temporary.

Check out Figure 9-14. In the short run, a fall in energy costs increases aggregate supply from SRAS₁ to SRAS₂ and takes the economy from point A to point B by reducing the price level and increasing output. If energy prices were to return to their original level, short-run aggregate supply would shift back from SRAS₂ to SRAS₁, meaning that the price level would go back up and output would fall to its original level. If, however, the fall in energy prices was permanent, you’d expect long-run aggregate supply to also shift from LRAS₁ to LRAS₂, meaning a permanently higher level of output.

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Figure 9-14: The effect of a fall in energy prices.

But what about countries whose economies are major energy producers, such as Saudi Arabia or Russia? Here, things are a little different. Although domestic firms that use energy still find producing output easier, you need also to take into account that the energy being produced makes up a substantial portion of the goods and services being produced domestically. When the price of energy falls, the value of the goods and services being produced falls, and because real GDP is defined in terms of the value of goods and services, it also falls.

Here’s another way of thinking about it. Russia produces a lot of energy – more than it can reasonably consume. When energy prices are

high, it can convert that surplus energy into other goods and services at an attractive rate. But when energy prices are low, it can only convert energy into other goods at a poor rate, so reducing living standards and aggregate supply.