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

 
9.7 SUPPLY SHOCK 
 
From 1930s to the late 1960s it was generally assumed that 
the movements in output and prices in the economy were caused 
by shift in the aggregate demand curve by changes in monetary 
and fiscal policy and investment demand. But the macroeconomic 
experience on 1970s was largely a story of Supply Shock. 
A supply shock is a disturbance to the economy whose fiscal 
impact is to shift the aggregate supply curve. 
Supply shock is attributed to change in material prices. 
When the material prices such as the oil prices change the AS 
curve will shift. An increase in material price will shift the AS curve 
upward. This is termed as an Adverse Supply Shock. This is 
shown in the following diagram. 

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FIGURE 9.9: AN ADVERSE SUPPLY SHOCK 
Initially the full employment output equilibrium is given at E 
where the short run aggregate supply curve (SAS) intersects the 
aggregate demand curve (MDS). 
An adverse supply shock such as increase in oil price, shift 
the aggregate supply curve to SAS . The rise in prices will reduce 
real money supply raise the interest rate and reduce the aggregate 
demand. The new equilibrium is obtained at E
1
where output is 
lower and a price is higher. 
Thus an adverse supply shock unfortunate, because it 
increases unemployment and prices (reduces the output from Y* to 
Y
1
) in the short period. 
But latter the unemployment at E
1
will push down the wages 
and thereby the prices. The wages fall slowly and the adjustment 
takes place along the MDS curve. Thus the economy moves back 
from E
1
to E. 
At ‗E‘ the economy is back at full employment and with the 
price level the same as it was before the shock, because the 
unemployment in mean time forced the wage down. Thus the real 
wage is lower than it was before the shock. 
The adverse supply shock has reduced the real wage in long run.