Page 707 - The Principle of Economics

CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 727
Long-run
aggregate AS2
supply
C A
Short-run aggregate supply, AS1
AD2
Aggregate demand, AD1
1. When short-run aggregate supply falls . . .
2. . . . policymakers can accommodate the shift by expanding aggregate demand . . .
4. . . . but keeps output at its natural rate.
Price Level
P3 P2
P1
0 Natural rate of output
Figure 31-11
ACCOMMODATING AN ADVERSE SHIFT IN AGGREGATE SUPPLY. Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who can influence aggregate demand might try to shift the aggregate- demand curve to the right from AD1 to AD2. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P1 to P3.
3. . . . which causes the price level to rise further . . .
Quantity of Output
curve by shifting the aggregate-demand curve. This possibility is shown in Fig- ure 31-11. In this case, changes in policy shift the aggregate-demand curve to the right from AD1 to AD2—exactly enough to prevent the shift in aggregate supply from affecting output. The economy moves directly from point A to point C. Out- put remains at its natural rate, and the price level rises from P1 to P3. In this case, policymakers are said to accommodate the shift in aggregate supply because they allow the increase in costs to affect the level of prices permanently.
To sum up, this story about shifts in aggregate supply has two important implications:
N Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices).
N Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.
CASE STUDY OIL AND THE ECONOMY
Some of the largest economic fluctuations in the U.S. economy since 1970 have originated in the oil fields of the Middle East. Crude oil is a key input into the production of many goods and services, and much of the world’s oil comes from Saudi Arabia, Kuwait, and other Middle Eastern countries. When some event (usually political in origin) reduces the supply of crude oil flowing from this region, the price of oil rises around the world. U.S. firms that produce gaso- line, tires, and many other products experience rising costs. The result is a left- ward shift in the aggregate-supply curve, which in turn leads to stagflation.