The Phillips Curve

Supply Shocks & Stagflation

coreExam · medium

A supply shock raises the markup m or the labour-market catchall z, lifting un. The Phillips curve π = πe − α(u − un) shifts up when un rises. The CB faces a dilemma — tighten to fight inflation (deepening recession) or accommodate (entrenching higher inflation). The 1970s oil shocks are the canonical example.

Derivation

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Anatomy of a Supply Shock

A supply shock raises the inputs to the natural rate:

u_n = \frac{m + z}{\alpha}

$\uparrow m$ (oil, raw materials pass-through) or $\uparrow z$ (union militancy, regulation) → $\uparrow u_n$ .

What Happens to Inflation

With $u$ unchanged, inflation rises via the Phillips curve:

\pi = \pi^e - \alpha(u - u_n^{\text{new}})

Since $u_n^{\text{new}} > u_n^{\text{old}}$ , at the same $u$ , inflation is higher.

Stagflation: high unemployment + high inflation simultaneously — impossible under pure demand shocks, natural under supply shocks.

The CB's Dilemma

| Option | Consequence | |--------|-------------| | Tighten ( $\uparrow i$ ) | Bring $\pi$ down by deepening recession | | Accommodate | Let $\pi$ rise, but $\pi^e$ drifts up |

Under adaptive expectations, accommodating a persistent shock leads to an inflation spiral. This is what happened in the 1970s, broken only by Volcker's painful 1979–82 disinflation.

The 1970s

| Year | Event | |------|-------| | 1973 | Arab oil embargo (4× oil price) | | 1974–75 | Stagflation: 11% inflation + 9% unemployment | | 1979 | Iranian revolution (2nd oil shock) | | 1979–82 | Volcker tightening — disinflation at the cost of deep recession |

Transitory vs Persistent Shocks

The CB should look through transitory shocks (one-off price spikes) but respond to persistent ones. Misreading the nature of the shock is a common policy error.

Worked Example

α = 0.5. Baseline m = 0.1, z = 0.1 → un = 40% (for illustration). Oil shock raises effective m to 0.15.

New un = (0.15 + 0.1)/0.5 = 50%. un rose by 10 pp.
At unchanged u = 40%: π = πe − 0.5·(0.40 − 0.50) = πe + 5 pp. Inflation jumps by 5 pp.
To keep π at its old level, u must rise from 40% to 50% — a 10 pp recession deepening.
Accommodation route: π rises; πe follows next period; π rises again. Spiral.

Supply shock: un rises 10 pp. At old u, π jumps 5 pp. CB must choose — tighten (u rises to 50%, π stable) or accommodate (spiral).

Common Mistakes

—Treating supply shocks like demand shocks — demand raises both π and Y; supply raises π but lowers Y.
—Ignoring the distinction between transitory and persistent — one-off oil price spikes aren't the same as OPEC embargoes.
—Assuming the CB has a free choice — both options (tighten or accommodate) involve real costs.
—Applying the standard Phillips curve without shifting un — a supply shock is really a shift in un.

Exam Cues

→Supply shock: ↑m or ↑z → ↑un → PC shifts up → stagflation.
→Policy dilemma: tighten (deepen recession) vs accommodate (inflation drift).
→1970s oil shocks: classic example. Led to dual shocks — oil price AND worker militancy (↑z).
→Shock types: demand (AD shifts) vs supply (AS/PC shifts) give opposite π-Y patterns.