Phillips Curve and Supply Shocks - Online Tutor, Practice Problems & Exam Prep

Supply shocks, such as unexpected increases in input prices like gasoline, shift the short-run aggregate supply curve leftward, leading to higher inflation and increased unemployment. This results in a rightward shift of the short-run Phillips curve, indicating a trade-off where policymakers face the challenge of combating both rising inflation and unemployment simultaneously. The situation exemplifies the complexities of aggregate demand management and the adverse effects on GDP, necessitating careful economic policy considerations.

Shifting the Phillips Curve:Supply Shocks

Now, let's see how a shift in our short-run aggregate supply is going to affect our Phillips curve. So when we talk about shifts in our short-run aggregate supply, it's due to something called a supply shock. It's some sort of unexpected event that affects a firm's production cost and shifts the aggregate supply curve. Okay? So we're going to be shifting our aggregate supply curve either left or right. Generally, when we talk about a supply shock, it's usually something like input prices have increased, okay? So something like input prices like gasoline have unexpectedly increased. So there's some shortage of gasoline, and now prices are much higher for gasoline. A lot of products use gasoline to, firms use gasoline to create their product. So the input prices are higher in that case. So let's go with that example here and lets see what happens in the short-run Phillips curve when we have this supply shock. Okay. So a sudden increase in gas prices affects the input prices of firms' production. So this is the supply shock right here. This is an unexpected increase in the input price. Okay? It could also be an unexpected decrease. Now, there's a bunch of gasoline available, and there's a decrease. But generally, when you see this, it's going to be a situation where there's an increase. Okay? So higher input prices, that's bad for supply, right? That's a bad thing for supply. So if we go down to our ADAS model, our supply curve would be shifting to the left. We would have a shift to the left due to this supply shock. So SRAS1 Short Run Aggregate Supply would shift to SRAS2. Remember that here we have our price level and our GDP. And in the short-run Phillips curve, we've got the inflation rate and the unemployment rate. Okay.

Let me get out of the way here. So we have this shift to the left in our short-run aggregate supply. So what does this do? Notice, we had this original equilibrium right here. At this original equilibrium, we had this level of GDP. Let's say it was right here. We'll just call it GDP1 and price1 and it scoots up to this new point, right? At this new equilibrium, and we have less GDP. There's less GDP and higher prices. This sounds doubly bad, right? This sounds like a double bad thing happening in the economy, right? So this is more inflation and more unemployment, right? So over here, I'm going to write more unemployment. Right? Because if there's lower GDP, that means there are fewer people employed to create the output in our society, so there's more unemployment. They don't need as many workers at this level of GDP. So we have 2 bad things. We have more inflation and more unemployment. That's doubly bad. So how that affects our short-run Phillips curve, well remember our short-run Phillips curve looks something like this. So our short-run Phillips curve might have looked something like this. I'll say PC for Phillips Curve1. Well, now at any level, we have higher inflation and a higher unemployment rate. So this is shifting our Phillips curve to the right and we're gonna be in a situation where at any level, we're going to have a higher, higher unemployment and higher inflation. So a decrease in aggregate supply leads to, a shift to the right in our oh, let me make that fit. A shift to the right in our short-run Phillips curve. Okay? So it's doubly bad when we have a supply shock that shifts our aggregate supply to the left. Well, both unemployment and inflation increase, so we're going to see that short-run Phillips curve shift to the right. Okay?

So as aggregate supply decreases, we see output decrease and the price level increase. So this leaves policymakers in a difficult position, right? Now they have to fight both higher inflation and higher unemployment at the same time. So they're fighting both high inflation and high unemployment. So that makes it much more difficult. Remember, there's always going to be this trade-off. If we try and decrease our unemployment, well, inflation is going to pop up even higher, right? If we try and mitigate the inflation, well, we're going to have even worse unemployment, alright? So that's the double jeopardy that we get put in when we have a shift, a supply shock, and a downward shift in our aggregate supply. Cool? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the Phillips Curve and how does it relate to inflation and unemployment?

The Phillips Curve illustrates the inverse relationship between inflation and unemployment in the short run. It suggests that as inflation increases, unemployment tends to decrease, and vice versa. This trade-off occurs because higher inflation often results from increased demand for goods and services, which boosts production and reduces unemployment. Conversely, lower inflation can lead to higher unemployment as demand decreases. However, this relationship may not hold in the long run due to factors like expectations and supply shocks.

How do supply shocks affect the short-run Phillips Curve?

Supply shocks, such as unexpected increases in input prices like gasoline, shift the short-run aggregate supply (SRAS) curve leftward. This leads to higher inflation and increased unemployment, causing a rightward shift in the short-run Phillips Curve. Essentially, at any given level of unemployment, the inflation rate is now higher. This complicates policy decisions, as efforts to reduce inflation may worsen unemployment and vice versa.

What are the implications of a leftward shift in the short-run aggregate supply curve?

A leftward shift in the short-run aggregate supply (SRAS) curve indicates a decrease in aggregate supply, often due to higher input prices or other supply shocks. This results in higher price levels (inflation) and lower GDP, leading to increased unemployment. Policymakers face a challenging situation as they must address both rising inflation and unemployment simultaneously, making it difficult to stabilize the economy.

Why do supply shocks create a 'double jeopardy' for policymakers?

Supply shocks create a 'double jeopardy' for policymakers because they lead to both higher inflation and higher unemployment. This dual challenge complicates economic policy decisions. Efforts to reduce inflation, such as tightening monetary policy, can exacerbate unemployment. Conversely, measures to reduce unemployment, like increasing government spending, can further fuel inflation. This trade-off makes it difficult to achieve economic stability.

How can policymakers address the challenges posed by supply shocks?

Policymakers can address the challenges posed by supply shocks through a combination of monetary and fiscal policies. They may use targeted fiscal measures to support affected industries and workers, while employing monetary policy to manage inflation expectations. Additionally, structural reforms to improve productivity and reduce dependency on volatile inputs can help mitigate the impact of future supply shocks. Balancing these approaches is crucial to minimize the adverse effects on the economy.