Unit 5 Macroeconomic policy: Inflation and unemployment
5.5 A negative (inflationary) supply shock and the monetary policy dilemma
In Section 4.9, we analysed the impact of a negative supply shock (such as a rise in real oil prices), which cuts real wages and as a result stimulates inflation. We shall learn that, in contrast to the demand shocks discussed in Section 5.3, supply shocks present policymakers with a clear policy dilemma. If they wish to bring inflation back on target they can do so only by policies that cause output and employment to fall. Since the central bank’s primary objective is to keep inflation as close as possible to target, this is usually considered as a dilemma for monetary policy in particular. So we shall focus primarily on the perspective of the central bank in setting monetary policy.
Figure 5.7 illustrates the problem in the context of the model we introduced in Unit 4.
Figure 5.7 A negative supply shock and the policy dilemma.
A negative supply shock
If output falls
If output remains unchanged
We again assume that before the shock hits, the economy is in the same initial equilibrium as assumed previously—the policymaker’s ‘sweet spot’. So the economy is initially both in supply-side equilibrium and with inflation equal to the target rate.
In the top panel, the effect of the higher oil price is to shift the PS curve down, implying there must be a cut in real wages (since the model economy is always on the PS curve). The only way that supply-side equilibrium can be restored is if the economy moves from the initial equilibrium at point A to point C, where both real wages and employment have fallen and the economy is once more at a WS–PS intersection. This is why we usually refer to this as a negative supply shock.
In economics, it is very important to be clear when we are referring to what happens in a model of the economy, sometimes called the model economy, and when we are referring to the real world.
The policy dilemma arises if the economy does not move directly to point C and it will not automatically do so. Suppose that, in the bottom panel, output stays at its initial level, at point A. If so, employment will also stay unchanged, so in the top panel there is a move to point B on the PS curve. This opens up a positive bargaining gap, which means that a negative supply shock is inflationary. Therefore in the middle panel, the Phillips curve shifts upwards, so that at the initial level of output the move to point B causes inflation to go up from 2% to 4%.
So here is the dilemma. As discussed in Section 5.1, voters do not like it when inflation goes up. They also do not like it when employment goes down. But if the central bank is given the responsibility of keeping inflation on target, it cannot simultaneously keep people happy on both counts. If it is to satisfy its objective, it must eliminate the bargaining gap, which is the source of the increase in inflation. If it does not, the Phillips curve will shift up again and inflation will rise further (to point D). To do that, in the top panel it must cause employment to fall and to bring this about, it must bring about a fall in aggregate demand (in the bottom panel).
Addressing the policy dilemma
How will the central bank make this happen? It only has a single policy tool, the nominal policy interest rate. It needs to raise this by enough that real interest rates rise. From the Fisher equation, this means that the policy rate needs to rise by more than expected inflation. And real interest rates in turn need to rise by enough that the resulting impact is to shift the AD curve down, as shown in the bottom panel of Figure 5.8, to a new equilibrium at a lower level of output at point C.
Figure 5.8 A negative supply shock: addressing the policy dilemma by tightening monetary policy.
Achieving this is by no means an easy or straightforward task. Later in this unit, we work through the details of the ‘monetary policy transmission mechanism’ by which changes in the real interest rates affect output, employment, and inflation. At this stage, we shall simply assume that the central bank raises interest rates by enough, which in turns lowers output and employment enough, such that supply-side equilibrium is restored at lower employment in the top panel. This in turn will eliminate the bargaining gap, and remove the inflationary pressure.
Figure 5.7 brings out another crucial aspect of the process. What if the central bank delays its policy response? As Unit 4 showed, the risk is that the rise in inflation will become embedded in inflation expectations. At an unchanged level of employment, this will shift the Phillips curve upwards, and hence inflation will rise further to point D. If, belatedly, the central bank now raises interest rates by enough to push the economy to point C in the bottom panel, this will again restore supply-side equilibrium and therefore stabilize inflation. But the middle panel shows that inflation will stabilize at a rate above target inflation, at point E. So the central bank’s task is not yet over: if nothing else changes, it will need to tighten policy further to bring inflation back to target. We come back to this problem in Section 5.9.
So, central banks have to carry out a very delicate balancing act. If they overreact to a supply shock, they may take the economy into an unnecessarily deep recession. But if they under-respond, they will simply have a bigger problem to deal with in due course.
It should also be clear why central banks take a keen interest, not just in inflation itself, but also in inflation expectations. In Section 5.10 we shall also discover that, simply by doing its job reliably and keeping inflation close to target, the central bank may in turn be able to prevent inflation expectations from shifting upwards, thereby making its own job easier. But, crucially, we shall learn that it will only be able to do so if it confronts the policy dilemma, and shows that it will always be willing to raise unemployment to prevent inflation taking off.
A warning
Using simple diagrams like Figures 5.5–5.8 may give the impression that the policymaker is able to stabilize output, employment, and inflation by accurate diagnosis of a shock, and then respond by a change in fiscal or monetary policy that achieves the desired result. This is far from the case! It is often difficult to decide, for example, whether a downturn is a temporary blip or signifies a long-term weakness, or whether a rise in prices is indicative of a supply shock or is restricted to relative price rises in a part of the economy. It can also be far from clear whether a rise in inflation signifies a change in inflation expectations or not.
Policymakers and their economic advisers rely on economic forecasts but the complexity of the economy and the inherent unknowability of what will happen in the future mean that forecasts are often wrong. Models help economists to improve economic forecasting and to organize their thinking about the causal links in the economy and hence what policies might be warranted. They do not give a recipe for the kind of precise stabilization shown in Figures 5.5 and 5.6.
Having stepped through the mechanics of a simplified model in which policymakers can use fiscal or monetary policy to respond to shocks, we now turn to the details of both types of policy.
Exercise 5.3 Illustrating supply and demand shocks
Draw WS–PS, Phillips curve, and AD diagrams to illustrate how policymakers could use fiscal and/or monetary policy to address the following shocks. Briefly describe the consequences of inaction.
- A rise in autonomous consumption
- A fall in oil prices (assuming no delay in policy response)
- A fall in oil prices (assuming a delay in policy response)
