Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
Another Possible Outcome: 
Another outcome is the firm will reduce the consumption of 
inputs (oil) whose price has increased. This will reduce the marginal 
0
Output
Pr iceLevel
'
MDS
MDS
1
E
E
P
P'
'
E
1
P
SAS
'
SAS
Y'
*
Y

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product of labour and labour demand curve shift to the left, crossing 
the labour supply curve at a lower level of employment. This will 
mean the potential output is permanently reduced with higher price 
and it can remain as long run position. 
Accommodation of Supply Shock:
After increase in material prices or after the supply shock, 
the government can prevent the output and employment from 
falling by an accommodating monetary and fiscal policy. This will 
shift the AD or MDS curve to the right to the MDS then the 
economy would have moved to E . This would have maintained the 
full employment output and money at previous level. However, 
prices would have increased from P to P , with the result that the 
real wages are reduced. But even without accommodating the 
policy, the real wages would have been decreased in any wage as 
is seen from the movement from E
1
to E. 
Supply Shock and Stagflation: 
It is quite clear from above that an adverse supply shock 
lead to stagflation. Stagflation occurs when Inflation take place and 
output is neither falling and nor rising. 
According to diagram given earlier, supply shock shift (SAS) 
up and output fall to Y
1
while price level increases to P
1
. 
Thus supply shock is an exemption to the Phillips curve 
which brought out inverse relation between interest rate and 
unemployment. As a result of supply shock unemployment 
increases with an increase in price level. Stagflation defined as a 
combination of economic stagflation and inflationary is a 
consequence of supply shock.