Question

Explain the favourable supply shock the US economy witnessed during 1990’s. What happened to inflation and unemployment rate during that time?

Answer 1

Supply shocks influence companies ' ability to produce the gross domestic product, which means that either costs or amounts of factor 6 products or manufacturing technology are directly affected. The resulting performance improvements can be regarded as fundamentally neo-classical in nature. On the other hand, shocks in demand affect households, businesses, and governments that buy GDP spending. Clearly, if the economy has Keynesian properties, any demand shock will have short-run Keynesian consequences (e.g., result in real output changes).

Supply shocks are events that change prices and actual production in opposite directions on effect (e.g., an adverse shock causes prices to rise and output to fall). Demand shocks are events that drive prices and real production in the same direction on effect (e.g., an expansionary demand shock is pushing up both prices and output).

During the time of the two oil shocks, the prices of other imported products (in addition to fuel) have increased significantly. Extending the Bruno-Sachs model to include multiple imported products and estimating the real GDP impact of their price increases is straightforward. Nevertheless, even with this expansion, the effect of the supply shocks is much smaller than the declines observed in GDP. The supply-side reduction in real output from higher oil and non-oil material prices cumulates to 1.6 percent for 1973-75, while the corresponding OPEC II estimate is 1.9 percent.

However, the pure neoclassical point of view does not offer any particular reason to believe that unemployment will increase after an oil shock. In this sense, real wages and the rate of income drop by enough to keep full employment of labor and capital. In other words, a purely neoclassical oil shock equally reduces actual and potential output, leading to no GDP gap (if the gap is correctly measured). Nevertheless, the U.S. unemployment rate actually rose from 4.8% in the second half of 1973 to almost 9% in the second quarter of 1975.

Aircraft can easily respond to higher fuel costs, but the higher energy costs used to produce aircraft are unlikely to appear on aircraft for years. That said, significant second-round price effects are still possible. Indeed, as could be expected, after the first two oil shocks, energy-intensive consumer goods and services posted relatively larger price increases.