| | | | | | operate too slowly to satisfy participants, so there is a need for policy action. This is the essence of the Keynesian message. | | | | | | | | | 5.7
Analyzing Supply Shocks | | | | | | | | | Although we can now recognize that Keynesian analysis did contain an implicit supply curve, prior to the 1970s this supply curve was kept hidden. Rather than using an aggregate-supply/aggregate-demand diagram such as those portrayed in figures 5.3 and 5.4, economists used alternative diagrams that did not explicitly show the supply side of the economy. As a result, they tended to forget about or unintentionally denigrate the role of the supply side in affecting economic activity. | | | | | | | | | The suppression of the role of aggregate supply became painfully evident when Keynesian analyses were unable to suggest appropriate policies to deal with the major supply shocks of the early 1970s. With the aggregate-supply/aggregate-demand diagram, the impact of a supply-side shock can be analyzed more easily. Suppose the economy is at position A in figure 5.5, and a negative supply-side shock perhaps an increase in the price of energy hits the economy. (Since 1970 the world has experienced four major energy price shocks, resulting from the following events: 1973 OPEC oil embargo [causing oil prices to triple], 1979 Iranian revolution, 1985 OPEC price crash, and 1990 Iraq-Kuwait war.) The resulting higher production costs cause the SRAS curve to shift upward to SRAS'. The LRAS curve should also shift slightly to the left to LRAS', for two reasons. First, because energy is now more expensive, less energy will be used per worker, so workers will become less productive, implying that output produced by a given quantity of labor will be less. Second, the fall in worker productivity causes the real wage corresponding to equilibrium in the labor market to fall, prompting some workers to leave the labor force. In the new long-run equilibrium the number of workers becomes smaller. The LRAS curve reflects long-run activity in the labor market. In the long run a smaller number of less productive workers corresponds to equilibrium in the labor sector, so the LRAS curve must be further to the left. An alternative way of viewing this fall in worker productivity may be helpful: the higher price of energy requires that more output be sent abroad in payment to oil producers, implying that there is less output left over to be distributed to workers. (If energy were produced domestically rather than imported, the result would not be so clear the fall in output noted earlier would be offset by the rise in the value of our energy output.) | | | | | | | | | In this situation, firms may begin by increasing prices to pass on the higher cost of energy, moving the economy to point B. The higher price lowers aggregate demand, and firms react by cutting back production, laying off workers, and moving the economy over to point C. At this stage the government may adopt a fiscal policy that shifts AD rightward to AD'. | | | | | | | | | Care must be taken not to overstimulate and try to push the economy all the way back to the original LRAS this response would create further price increases. The biggest com- | | | | |
