Question

How will negative supply shock affect the economy? Explain using the three equation model and Central Bank's response in controlling the same.

Answer 1

A supply shock is an unexpected event that changes the supply of a product or commodity, resulting in a sudden change in price. A positive supply shock increases output causing prices to decrease which may lead to deflation, while a negative supply shock decreases output causing prices to increase, which basically leads to inflation.

The 3 equations are the IS equation y1 = A−ar0 in which real income y is a positive function of autonomous expenditure A and a negative function of the real interest rate r; the Phillips curve π1 = π0 + α(y1 − ye), where π is the rate of inflation and ye, equilibrium output; and the central bank's Monetary Rule.

In the case of a negative supply shock, the central bank has a policy dilemma as economic activity and inflation move in opposite directions. Here, the central bank either temporarily accepts higher inflation, or in an attempt to keep inflation right on target it reinforces the disturbance driving down output.These are the ways the Central Bank can control Negative Supply Shock.