Supply-side shocks are unexpected events affecting costs and prices in different countries. An aggregate supply shock is either an inflation shock or a shock to a country’s potential national output.
Adverse aggregate supply shocks of both types reduce output and increase inflation and can increase the risk of stagflation for an economy. For example a rise in the world price of crude oil or natural gas. Or perhaps an unexpected and sizeable change in world prices of foodstuffs used both for direct consumption and also as an input into the production of manufactured foods.
The effects of supply-side shocks are normally to cause a shift in the short run aggregate supply curve (shown below).
But there are also occasions when significant changes in production technologies or step-changes in the productivity of factors of production that were not expected, feed through into a shift in the long run aggregate supply curve.
When analysing supply-side shocks in your economics exam:
1/ Make good use of AD-AS analysis (use your AS economics!)
2/ Consider short-run and possible longer-run effects
a/ First round effects (immediate or short term)
b/ Second round fallout (medium term effects – can be positive or negative)
Further evaluation might consider:
*The impact of higher shocks will vary from country to country
*How big is the supply shock? Is the shock temporary or more persistent?
*Consider how macroeconomic policy might respond to the shocks - for example how might a central bank respond to an inflationary shock? With an immediate increase in policy interest rates? or might it leave interest rates alone because it feels that the supply-side shock causing inflation to spike higher is probably only a temporary effect?