212 Policy Implications: Supply Shocks and Economic Growth (191/108) -- Macroeconomics

212 Policy Implications: Supply Shocks and Economic Growth Learning Objectives - Explain why there is no good policy response to a negative aggregate supply shock - Differentiate between the fiscal and monetary policies a neoclassical economist would recommend to promote economic growth and those a Keynesian economist would recommend Responding to Real Shocks to the Economy Changes in aggregate demand always result in unemployment going one way, while inflation goes the other, at least in the short run. We saw this on the previous page, where a decrease in AD caused an increase in unemployment, but a decrease in the price level, and an increase in AD caused the opposite. Changes in aggregate supply push inflation and unemployment in the same direction at the same time. If the shock is positive, shifting AS to the right, this is very, very good since both inflation and unemployment fall. But if the shock is negative, shifting AS to the left, the output is not good since both inflation and unemployment rise. This is stagflation, which happened during the 1970s. In the latter case, there is no good policy option since an expansionary fiscal or monetary policy while lowering unemployment would make inflation worse. A contractionary fiscal or monetary policy could reduce inflation, but cause greater unemployment. Figure 1 illustrates the effects of a rapid increase in the price of oil. This negative real shock would cause the LRAS to shift to the left, which causes not only a decrease in GDP, but an increase in inflation. These two issues (recession and high inflation) typically require opposite policies from the Fed. To decrease inflation, the Fed could decrease the money supply and reduce aggregate demand, but that would only make the recession deeper. Or they could increase real output by decreasing interest rates, stimulating aggregate demand, but that would likely cause even higher inflation. This is precisely why there is no easy answer to this situation. Try It Policy in Practice Negative real shocks are more complicated than shocks to aggregate demand. A real-life example of this occurred in the 1970s. The recession of 1974-75 was caused by adverse supply shocks, primarily the Oil Crisis which occurred when the Arab members of the Organization of Petroleum Exporting Countries (OPEC) embargoed petroleum exports, driving up the price of oil. Since oil is used in the manufacturing of most goods and services, this was a very large supply shock. This recession was, at the time, the worst economic downturn since the Great Depression. The Federal Funds Rate peaked in mid-1975 as the Fed aggressively cut interest rates to stimulate aggregate demand and reduce unemployment. The Ford Administration conducted an expansionary fiscal policy, driven largely by tax cuts, which you would expect from a Republican (and thus neoclassical) administration. The economy recovered, but inflation went even higher, peaking at nearly 14% in mid-1980. Watch It Watch the