In economics, a supply shock refers to an unexpected event that significantly alters the production costs for firms, leading to shifts in the short-run aggregate supply (SRAS) curve. When a supply shock occurs, such as a sudden increase in input prices like gasoline, the SRAS curve typically shifts to the left. This leftward shift indicates a decrease in aggregate supply, resulting in higher prices and lower output.
To illustrate, consider a scenario where gasoline prices unexpectedly rise due to a shortage. This increase in input costs negatively impacts firms' production capabilities, leading to a new equilibrium characterized by reduced GDP and increased price levels. As a result, the economy experiences both higher inflation and higher unemployment, creating a challenging situation often referred to as "stagflation." In this context, lower GDP implies that fewer workers are needed, contributing to rising unemployment rates.
The relationship between inflation and unemployment is depicted by the Phillips curve, which typically shows an inverse relationship between the two. However, when a supply shock occurs, the short-run Phillips curve shifts to the right. This shift signifies that at any given level of unemployment, inflation rates are now higher than before. Consequently, policymakers face a difficult dilemma: they must address both rising inflation and increasing unemployment simultaneously. This situation complicates economic management, as efforts to reduce unemployment may exacerbate inflation, and vice versa.
In summary, a decrease in aggregate supply due to a supply shock leads to higher inflation and higher unemployment, resulting in a rightward shift of the short-run Phillips curve. This scenario presents significant challenges for policymakers, who must navigate the trade-offs between inflation and unemployment in their economic strategies.
