Figure 5.5 Reaction to a Supply-Side Shock The shock of higher energy costs shifts SRAS to SRAS' and LRAS to LRAS'. Firms pass on the higher cost by increasing prices, moving the economy from A to B. The price rise lowers demand, and firms cut output, moving the economy to C. Further reaction depends on how workers respond to the fall in their real wage and the nature of government policy action.
plication, however, arises from workers' reaction to the price increase. If workers recognize their decreased productivity and accept the fall in their real wage, the economy could settle at D in figure 5.5. More realistically, however, workers may demand wage increases to prevent their real wage from falling. This would shift the SRAS further upward (not shown in figure 5.5), leading to more price increases and frustrating the fiscal policy. Unemployment will be maintained (i.e., the economy will remain to the left of LRAS' at a position like C) as long as employed workers prevent the real wage from falling to reflect their decreased productivity.
5.8 Supply-Side Economics
Some economists came to believe that economic forces springing from the supply side were strong enough to play a major role in determining the level and character of economic activity. Such economists developed what has become known as supply-side economics.
