What Is Meant by a Shock to Aggregate Supply - Essay Example

A. What is meant by a shock to aggregate supply? In order to understand the sense of ‘shock’ when referring to aggregate supply, we should primarilyexamine the meaning of ‘aggregate supply’. In this context, we could refer to the definition of this term given by Truett et al. (1998,). In accordance with this definition aggregate supply is ‘the relationship between the real quantity supplied of newly produced final goods and services in an economy and the general price level’ (Truett et al. (1998, 71). In other words, aggregate supply represents the ‘balance’ between products/ services offered within a particular market and the prices of these products/ services in the above market. The role of aggregate supply has been extensively examined in the literature. In this context, it has been found that ‘aggregate supply relationship typically links inflation surprises with fluctuations in the output gap, while potential output, defined as the flexible-price equilibrium output, is exogenous; based on such construct, micro-based interest rules respond exclusively to fluctuations in the inflation rates and the output gaps’ (Razin et al., 2005, 179). In accordance with the above view, aggregate supply can represent a particular relationship, this of output gaps and inflation rates. In fact, because aggregate supply refers to the balance between products/ services and the prices in a specific market, it is very likely that the turbulences of inflation rates (as a consequence of instability in the ‘balance’ described above) could be also considered as directly related with aggregate supply. The above views can be also supported by the fact that the differences in inflation rates in a specific market are thought to be closely related with the instability in aggregate supply (among other reasons) in the above market. Indeed, the study of Razin et al. (2005, 184) led to the assumption that ‘inflation is primarily affected by: (1) economic slack, (2) expectations, (3) supply shocks, and (4) the inflation persistence; thus, inflation depends on inflation expectations, the output gap, the (log) difference between the actual and flexible-price investment, and the (log) difference between the actual and flexible-price stock of capital’. Because of the influence of aggregate supply on the inflation rates, it could be expected that a radical change (extremely severe instability appeared unexpectedly) in aggregate supply could lead to severe financial consequences for the market involved. The above described unexpected changes in the relationship between products/ services offered and prices of these products/ services should be considered as a ‘shock’ to the aggregate supply within the market involved. In accordance with the above in order for the shock to aggregate supply to be avoided in a specific market, a balance should exist between products/ services and prices within the above market; however this balance should last for a long period (if the local economy would be benefited from the aggregate supply). Regarding this issue it is stated by Gamber et al. (1997, 680) that ‘output fluctuations are, to some extent, a function of permanent aggregate supply shocks; if, indeed, both aggregate demand and aggregate supply shocks are important determinants of economic fluctuations, then prior interpretations of reactions functions may be invalid’. More specifically, fluctuations in products/ services that last for quite a long can be characterized as a condition of ‘permanent aggregate supply shock’. In that case, local economy will face severe pressures and the increase of productivity (in both products and services) could be regarded as the only solution in order for this crisis to be limited. Figure 1 – Aggregate supply in its short and long run aspects (sources: Barnes and Noble, 2007, available at http://www.sparknotes.com/economics/macro/aggregatesupply/section3.rhtml ) An issue that should be highlighted is the fact that the effects of the supply shock could be characterized as either ‘long’ term or ‘short’ term (see also Figure 1 above). The long terms effects of the supply shock could be the following ones: decrease of the country’s financial performance and decrease of the credibility of the country towards its debtors. In other words, it would be more difficult for the country to seek for financial assistance by the international community while its power to promote its view on strategic issues internationally could be also influenced. On the other hand, other effects, ‘direct’ ones, could be also observed by the supply shock. In this context, the exports of the state would be reduced while the commercial activity of firms established in the specific country would be also limited. The supply shock within a state is often regarded as a weakness of the country to effectively handle the balance of production/ consumption (see the Figure 2 below referring to the balance between aggregate supply and aggregate demand) in its internal environment but also as a weakness to administer its resources (energy, agricultural production and so on). Figure 2 – Aggregate Supply (AS) – aggregate demand (AD) model (source: http://www.uri.edu/artsci/newecn/Classes/Art/INT1/Mac/Intro/Out.intromodel.html) Regarding the above, it could be noticed that the shock to aggregate supply can have a severe impact on the local economy. On the other hand, in conditions that prohibit the improvement of productivity in products/ services (like in periods of war or other severe military conflicts) there could be no particularly method for local economy to be protected. Only a possible financial support from the international community (or the European Union for member states) could help the national economy to face the challenges set by this instability. In the long term, the shock to aggregate supply can influence the performance of all sector of national economy while the development of one or more of these sectors would not be able to ‘cover’ the gap caused in the national economy by this shock. In fact, the study of Handa (2000, 396) showed that ‘competition, flexible wages and prices, and economic rationality of firms and workers are not enough to ensure that the economy will revert to full employment after an aggregate demand shock’. It seems that the shock to aggregate supply cannot be treated effectively without the action involvement of the government and the introduction and application of appropriate economic policies – an issue that is thoroughly examined in the following chapter. B. How can economic policy be implemented to counter such a shock? As already proved through the analysis made above the supply shock could have severe consequences for the state both in the short and the long term. Regarding this issue, it is noticed by Burdekin (1995, 167) that ‘the solution for the rate of growth of the price level with respect to the shocks indicates that supply shocks are deflationary (due to the rightward shift in the aggregate supply), while demand as well as monetary disturbances exacerbate the inflation rate’. In other words, the supply shock is not always easy to be handled especially if the country’s economy is not strong enough in order to manage effectively strong turbulences. The radical changes in the international financial markets are a negative influence for the country’s efforts to face its supply shock. In this context, one of the major priorities for countries within the international market should be the enforcement of their economy in order to be – at least up to a level – independent and autonomous towards the global economy. In other words, if a particular country has a stable level of production through the years it would be less likely for this country to suffer from a possible supply shock. However, such a target would be extremely difficult to be achieved especially because it would be difficult for all governments around the world to retain their production (all types of products related with the national economy) at a stable level especially under the current market trends (continuous turbulences within the international financial markets). For this reason, the introduction of appropriate policies related with the terms of production and the management of all country’s resources would be a valuable initiative in order for a country to be protected against potential supply shocks. The particular issue is mentioned by Elsner (2001, 61) who noticed that ‘economic-policy intervention will be specified as the public promotion of co-operative action among private agents with specific economic policy instruments’. The elements of the definition of aggregate supply as already developed above could justify the above proposals. More specifically, it is stated that ‘relative input costs and output prices are adjusted so that there is no excess quantity demanded or excess quantity supplied of any factor of production at any point on the aggregate supply curve’ (Truett et al., 1998, 71). From a different point of view, it is noticed by Kasper et al. (1995, 364) that ‘when the target problem is considered within a generalized macroeconomic model involving aggregate demand and aggregate supply and the latter exhibits random shocks or disturbances, the price level elasticity of aggregate demand assumes a major role in the evaluation and conduct of alternative monetary policy rules’. In accordance with the above view, a country’s monetary policy is of significant importance regarding the protection of the specific country from a potential supply shock. The above assumption is also supported by Handa (2000, 297) who noticed that ‘in the short run, maintaining a given target level of nominal income would mean that the exogenous shocks to aggregate demand would be offset through monetary policy and, therefore, will not impact on either prices or output’. However, it should be noticed that the existence of appropriate monetary policies within a particular state cannot guarantee that this state is protected against a possible supply shock. In fact, all other measures developed above should be also taken in order for such an outcome to be avoided. In any case, the measures taken by a country regarding its protection against a supply shock depend on its government’s policies as designed and applied on a long term perspective. References Burdekin, R., Langdana, F. (1995) Confidence, Credibility, and Macroeconomic Policy: Past, Present, Future. New York: Routledge Elsner, W. (2001) Interactive Economic Policy: Toward a Cooperative Policy Approach for a Negotiated Economy. Journal of Economic Issues, 35(1): 61-74 Gamber, E., Hakes, D. (1997) The Federal Reserves Response to Aggregate Demand and Aggregate Supply Shocks: Evidence of a Partisan Political Cycle. Southern Economic Journal, 63(3)680 Handa, J. (2000) Monetary Economics. London: Routledge Kasper, H., Kyer, B., Maggs, G. (1995) Monetary Policy Rules, Supply Shocks, and the Price-Level Elasticity of Aggregate Demand: A Graphical Examination. Journal Title: Journal of Economic Education. Volume: 26(4): 364-371 Razin, A. (2005) Aggregate Supply, Investment in Capacity and Potential Output. Journal of Money, Credit & Banking, 37(1): 179-186 Truett, L., Truett, D. (1998) The Aggregate Demand/supply Model: A Premature Requiem? American Economist, 42(1): 71-76 Read More