An event that shifts the short-run aggregate supply curve, such as a change in commodity prices, nominal wages, or productivity, is known as a supply shock. A negative supply shock raises production costs and reduces the quantity producers are willing to supply at any given aggregate price level, leading to a leftward shift of the short-run aggregate supply curve. The U.S. economy experienced severe negative supply shocks following disruptions to world oil supplies in 1973 and 1979. In contrast, a positive supply shock reduces production costs and increases the quantity supplied at any given aggregate price level, leading to a rightward shift of the short-run aggregate supply curve. The United States experienced a positive supply shock between 1995 and 2000, when the increasing use of the internet and other information technologies caused productivity growth to surge.

The effects of a negative supply shock are shown in panel (a) of Figure 12-13. The initial equilibrium is at E₁, with aggregate price level P₁ and aggregate output Y₁. The disruption in the oil supply causes the short-run aggregate supply curve to shift to the left, from SRAS₁ to SRAS₂. As a consequence, aggregate output falls and the aggregate price level rises, an upward movement along the AD curve. At the new equilibrium, E₂, the short-run equilibrium aggregate price level, P₂, is higher, and the short-run equilibrium aggregate output level, Y₂, is lower than before.

The combination of inflation and falling aggregate output shown in panel (a) has a special name: stagflation, for “stagnation plus inflation.” When an economy experiences stagflation, it’s very unpleasant: falling aggregate output leads to rising unemployment, and people feel that their purchasing power is squeezed by rising prices. Stagflation in the 1970s led to a mood of national pessimism. It also, as we’ll see shortly, poses a dilemma for policy makers.

A positive supply shock, shown in panel (b), has exactly the opposite effects. A rightward shift of the SRAS curve from SRAS₁ to SRAS₂ results in a rise in aggregate output and a fall in the aggregate price level, a downward movement along the AD curve. The favorable supply shocks of the late 1990s led to a combination of full employment and declining inflation. That is, the aggregate price level fell compared with the long-run trend. This combination produced, for a time, a great wave of national optimism.

The distinctive feature of supply shocks, both negative and positive, is that, unlike demand shocks, they cause the aggregate price level and aggregate output to move in opposite directions.

There’s another important contrast between supply shocks and demand shocks. As we’ve seen, monetary policy and fiscal policy enable the government to shift the AD curve, meaning that governments are in a position to create the kinds of shocks shown in Figure 12-12. It’s much harder for governments to shift the AS curve. Are there good policy reasons to shift the AD curve? We’ll turn to that question soon. First, however, let’s look at the difference between short-run macroeconomic equilibrium and long-run macroeconomic equilibrium.