Stagflation caused by a negative supply shock makes macroeconomic policy very difficult; trying to reduce the size of a recession caused by the shock leads to a higher price level.

Question

Quizplus · Accepted Answer

Stagflation caused by negative supply shock creates a situation where increasing aggregate demand through expansionary macroeconomic policies leads to both higher inflation and higher unemployment. Therefore, policymakers face a difficult trade-off between reducing unemployment and controlling inflation. Attempts to decrease unemployment or stimulate the economy through policies such as fiscal or monetary stimulus can further increase inflation, leading to a persistent cycle of stagflation. Thus, reducing the size of the recession caused by negative supply shock leads to a higher price level.

Stagflation Caused by a Negative Supply Shock Makes Macroeconomic Policy