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Aggregate Supply Shocks

Just as there are aggregate demand shocks, there may be shocks to aggregate supply, e.g., a change in the international prices of a oil, a change in productivity, etc. The aggregate apply shocks may also be (i) positive supply shocks, or (ii) negative supply shocks.

(i)    Positive Supply Shocks. A fall in the world prices of a oil would constitute a positive supply shock. As a result of this positive supply shock, the economy wills expectances a rise in output and a fall in prices. t will come to settle at a new equilibrium of higher GDP.

In this transmission two effects would follow:

One, as the price level falls the real money supply starts rising, and this in turn leads to lower interest rates. However, if the monetary authorities were bent on maintain the interest rates at the original level, they would be forced to reduce the money stock. In that event, real GDP will not rise, although the price level will come down.

Two to the extent that the real GDP increased in the economy due to the positive supply shocks, the economy would experience inflationary pressures. under the pull of these pressures, it would tend to go back to the original equilibrium.

(ii)    Negative Supply Shocks. Negative supply shocks, say in the form of a rise in the international prices of oil. In this situation, output levels in the economy will fall, whereas the general price level will rise. This type of situation is called stagflation.

This would occur only if the money stock is held constant. Then the logic would be that the rising price level reduces the real money supply, forcing up interest rates and thus leading to lower investment, which in turn lowers GDP.

However, if the monetary authorities want to maintain the original interest rate, they would have to increase the money supply with increased money supply, the price level would rise, but the real GDP will not fall.
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