National Income and AD/AS Analysis: Question 9

Worked solution

Part (a): Effect of the oil price rise on SRAS

Oil is a key imported input used throughout Doravia’s economy (in transporting goods, running factories and generating energy) so a sharp, sustained rise in its world price directly raises production costs for firms in almost every industry, not just one. Since firms are only willing to supply a given level of real output if it remains profitable to do so, this rise in costs means firms now require a higher price level to be willing to supply the same real output as before. Equivalently, at every existing price level, firms are willing and able to supply less real output than before. Doravia’s SRAS curve therefore shifts to the left (SRAS decreases).

Part (b): Effect on the short-run equilibrium

With AD unchanged and SRAS shifting left, the new short-run equilibrium is found where the unchanged, downward-sloping AD curve meets the new, leftward-shifted SRAS curve. Since the SRAS curve has shifted inward while AD stays in place, this new intersection point lies further up the AD curve than before: the equilibrium price level rises, while the equilibrium level of real output falls. Doravia therefore experiences a combination of rising prices and falling output at the same time, a situation often called stagflation.

Part (c): Discussing the trade-off compared with a demand-side shock

If Doravia instead experienced a fall in aggregate demand of a similar size (AD shifting left, with SRAS unchanged), the new equilibrium would show both a lower price level and lower real output/employment, the price level and output move in the same direction. In that case, a single expansionary demand-side policy (for example a cut in interest rates, shifting AD back to the right) could raise real output and employment back up while also raising the price level back toward its original level: one policy lever addresses both problems together.

The oil-price supply shock analysed in (a) and (b) is fundamentally different, because it moves the price level and real output/employment in opposite directions: the price level rises while output and employment fall. This creates a genuine policy dilemma. An expansionary demand-side policy aimed at restoring real output and employment (shifting AD rightward) would push the price level up even further, adding demand-pull inflation on top of the existing cost-push inflation. Conversely, a contractionary demand-side policy aimed at bringing the price level back down (shifting AD leftward) would push real output and employment down even further, deepening the very fall in output the shock has already caused. No single demand-side policy can improve both the price level problem and the output/employment problem simultaneously.

Overall, to the extent that a demand-side shock allows both goals to be pursued together with one policy tool, while a supply-side shock like this oil price rise forces a choice between prioritising the price level or prioritising output and employment, this negative supply shock does create a substantially more difficult trade-off for Doravia’s policymakers than an equivalent fall in aggregate demand, though the size of that trade-off would also depend on how large and how persistent the rise in oil prices proves to be, and on whether Doravia has other economic tools available beyond demand-side policy.

Final answers

• (a) The SRAS curve shifts leftward (decreases), since higher import costs raise production costs at every level of output.
• (b) With AD unchanged, the equilibrium price level rises and equilibrium real output falls, stagflation.
• (c) Unlike a demand-side fall (which moves price level and output/employment together), this supply shock moves them in opposite directions, so no single demand-side policy can fix both at once, making it a more difficult trade-off.