Inflation and the Phillips curve · Lesson 9 of 12
Supply shocks and stagflation
Until now unemployment and inflation moved in opposite directions: along the curve, a boom lowers one and raises the other. A supply shock breaks that pattern. It lifts the curve itself, so unemployment and inflation can rise together, and the policymaker has to choose between letting the inflation stay and paying for its removal.
A question to hold on to
A continuous supply shock leads to: (A) a continuous shift of the Phillips curve to the left, so that unemployment and inflation both fall. (B) A continuous shift of the Phillips curve to the right, so that unemployment and inflation both rise. (C) A continuous movement along the Phillips curve, so that unemployment and inflation both fall. (D) A continuous movement along the Phillips curve, so that unemployment falls and inflation rises.
UGC NET Economics, December 2024Solved at the end ↓
The idea
What a supply shock does
A supply shock is something that raises the cost of producing at every level of employment: a jump in the price of oil, a bad harvest, a disruption to shipping. Firms pass the cost into prices, so at the same unemployment rate inflation is now higher. On a diagram of inflation against unemployment the whole Phillips curve moves up. Because the curve slopes down, moving it up is also moving it to the right: at the same inflation rate there is more unemployment.
Add a shock term to the curve of Lesson 7 and it becomes the one this lesson works with:
The Phillips curve with a supply shock
A positive ε is an adverse shock. It acts like a rise in expected inflation: the curve moves up by ε for as long as the shock lasts. A favourable shock (a fall in oil prices) is a negative ε.
Compare this with a demand shock. A boom takes the economy along the curve to lower unemployment and higher inflation; a slump takes it along to higher unemployment and lower inflation. In both, unemployment and inflation move in opposite directions. A supply shock shifts the curve, so the two can move together. That is the opening question: a continuous supply shock means a continuous shift of the curve to the right, with unemployment and inflation both rising. Options C and D describe movements along the curve, which a supply shock does not cause, and option A has the curve shifting the wrong way (UGC NET 2024).
Pause and predict
Unemployment and inflation both rise together. Which move on the diagram explains it?
The definition
Stagflation, six ways
Stagflation is rising prices together with weak or falling output: inflation and unemployment both high. It is the standard symptom of an adverse supply shock, because a demand slump lowers inflation and a demand boom lowers unemployment, and only a shift of the curve gives both a bad outcome at once. Six past questions ask for the definition, in three wordings:
| Paper | How the options put it | Keyed answer |
|---|---|---|
| CUET 2024, JNU 2010, JNU 2013 | “Stagflation describes a situation of…” with rising or falling prices and rising or falling output | rising prices and falling or stagnant output |
| GATE 2023 | “Stagflation is a situation when…” with unemployment and inflation each low or high | both unemployment and inflation are high |
| Hyderabad 2010, Hyderabad 2015 | “Stagflation is a period of…” with high or low inflation and unemployment | high inflation and high unemployment |
The three wordings say the same thing: output down (unemployment up) while prices rise. The wrong options are the other three combinations, and the common trap is the pairing of low inflation with high unemployment, which is a demand slump.
Interactive
Try it: accommodate or fight
The economy of the Dial is hit by a shock. Start with “Accommodate a one-year shock”: unemployment stays at 5% and inflation steps up by the size of the shock and stays there. Then “Fight it hard” and “Fight it gently”: the same inflation comes back down, at the price of unemployment above 5%. Last, a shock that repeats every year.
The economy of the Dial: natural rate 5%, inflation steady at 2%, expected inflation equal to last year’s inflation. A supply shock lifts the whole Phillips curve by the size you set, for as many years as you set. Then you choose between accommodating it (unemployment stays at 5%) and fighting it (unemployment is held above 5% until inflation is back at 2%).
Curve before the shockCurve with the shockNatural rate, 5%
Inflation2% targetUnemployment (dotted) and the natural rate
The shock
Inflation peaks at 5% in year 1. Unemployment is 5% in year 1, so the first thing the shock does is raise inflation: 5% = 2 − 1 × (5 − 5) + 3.
After 12 years
Unemployment never leaves 5%, and inflation ends at 5%, 3 points above where it started. Nothing in the economy pulls it back, because expectations follow it up.
What to notice
Accommodation avoids the recession and keeps the higher inflation: a one-off shock leaves a permanent step in inflation, and a shock repeated every year makes inflation climb every year.
The price of fighting a shock
With expectations equal to last year's inflation (θ = 1), each point-year of unemployment above the natural rate removes β points of inflation, so removing a shock's worth of inflation costs the same however fast or slowly it is done.
The dilemma
Accommodate and the economy avoids a recession but keeps the extra inflation, and a shock repeated each year makes inflation climb each year. Fight and the extra inflation goes, at a cost of unemployment above the natural rate. Lesson 10 prices that cost.
The medium run
What a shock does to the natural rate
A shock to the price of an imported input such as oil also acts on the natural rate. One standard way to put it into the model of Lesson 8 is as a rise in the mark-up: firms pay more for a bought-in input and raise prices on each unit of labour cost. A larger m lowers the real wage price-setting allows, and in every wage-setting rule the natural rate goes up. Unemployment therefore rises in the medium run even if the policymaker does nothing, and the curve shifts right as well as up.
A word on conventions. Some treatments keep the natural rate fixed and let the shock shift the curve only. Then holding unemployment at its original rate means ever-higher inflation, which is the accommodation result of the lab above. The treatment here, with a mark-up channel, adds a rise in the natural rate. A question usually makes clear which it uses, by saying whether the natural rate changes.
| Wage-setting rule | Mark-up | Natural rate before | After the mark-up rises 5 points |
|---|---|---|---|
| Proportional: W/P = A(1 − u) | 25% to 30% | 20% | 23.08% |
| General: F(u, A) = A/u − 1 | 25% to 30% | 16.67% | 16.96% |
| Exponent: W/P = A^0.5 (1 − u)^0.5 | 10% to 15% | 17.36% | 24.39% |
| Union rule: W = Pᵉ(Z − αu) | 25% to 30% | 20% | 23.08% |
The Workbench defaults of Lesson 8 for each rule, computed from the closed-form natural rate. The direction is the same in all four.
A habit worth building
Which shock was it?
When a question gives you what happened to unemployment and inflation, read the pair of directions:
| Unemployment | Inflation | Most likely | On the diagram |
|---|---|---|---|
| falls | rises | a demand boom | along the curve, to the left |
| rises | falls | a demand slump | along the curve, to the right |
| rises | rises | an adverse supply shock | the curve shifts up and right |
| falls | falls | a favourable supply shock | the curve shifts down and left |
Traps
What examiners are fishing for
Watch out for
The mistakes examiners are fishing for
- Shift against move along. A supply shock shifts the curve; a demand change moves the economy along it.
- Low inflation with high unemployment is a slump, not stagflation.
- Up and to the right are the same shift. On a downward-sloping curve, higher inflation at each unemployment rate is the same as higher unemployment at each inflation rate.
- Accommodation keeps the inflation, it does not remove it. A one-off shock leaves a permanent step in inflation if expectations follow last year’s inflation.
- Fighting costs the same however fast, when expectations follow last year’s inflation. Speed changes when the cost is paid, not how large it is.
Worked questions
Worked questions
UGC NET December 2024 · standard (the opening question)
A continuous supply shock leads to?
- Shift or move along.A supply shock changes costs at every level of employment, so the curve itself moves. That rules out C and D.
- Which way.An adverse shock raises inflation at each unemployment rate: the curve moves up, which on a downward curve is also to the right. A leftward shift with both variables falling would be a run of favourable shocks. The key reads a continuous supply shock as continuing cost increases, so the curve keeps moving right.
- A continuous shock.The curve keeps moving up and to the right, and unemployment and inflation rise together.
Answer
(B): a continuous shift of the Phillips curve to the right, unemployment and inflation both rising.
CUET 2024 · foundation
Stagflation describes a situation of?
- Stagnation plus inflation.Stagflation joins the two words: stagnant or falling output, and rising prices.
Answer
Rising prices and falling or stagnant output.
GATE 2023 · foundation
Stagflation is a situation when?
- Translate output into unemployment.Stagnant output means high unemployment; rising prices mean high inflation.
Answer
Both unemployment and inflation are high.
Hyderabad 2015 · foundation
Stagflation is a period of?
- The same idea in the words of the options.High inflation and high unemployment. Low inflation with high unemployment is a slump.
Answer
High inflation and high unemployment.
Revise
The lesson on one screen
The lesson on one screen
- The curve
- π = πᵉ − β(u − uₙ) + ε. An adverse shock (ε > 0) lifts it.
- Shift or move along
- Supply shocks shift the curve; demand changes move along it.
- Stagflation
- Inflation and unemployment both high; rising prices with falling or stagnant output.
- Natural rate
- An input price rise acts like a higher mark-up and raises uₙ.
- Accommodate
- Hold u at uₙ: no recession, higher inflation stays (θ = 1).
- Fight
- Hold u above uₙ: inflation returns, at a cost of ε/β point-years for a one-off shock.
- Which shock
- u and π move together: supply. Opposite directions: demand.
Practice
Check yourself
Quick questions
1Stagflation is a period of
2An adverse supply shock shifts the short-run Phillips curve
3Unemployment and inflation both rise. The likeliest cause is
4Accommodating a one-off adverse supply shock, with expectations equal to last year's inflation,
5A rise in the price of an imported input, treated as a rise in the mark-up, makes the natural rate
Numerical problems
Accommodating a shock
θ = 1, β = 1, the natural rate is 5% and inflation has been 2%. A one-off 3-point supply shock hits in year 1 and unemployment is held at 5% throughout. What is inflation in year 4, in percent?
The price of fighting
θ = 1 and β = 0.5. Inflation is 3 points above target after a shock. How many point-years of unemployment above the natural rate does it take to remove it?
A shock every year
θ = 1, β = 1, inflation starts at 2% and unemployment stays at the natural rate. A supply shock of 1.5 points hits in each of years 1 to 4. What is inflation in year 4, in percent?
Fighting in one year
θ = 1, β = 1.5, the natural rate is 5% and inflation has been pushed up 3 points by a one-off shock. To bring it back down to target in the next year, what unemployment rate must be held that year, in percent?
Real questions
Past papers, by level
Foundation
Definitions, formulas and one-step problems. Most CUET, UGC NET and Hyderabad questions on this topic sit here.
6 questionsPractise →
Standard
Statements to judge, matching lists and calculations with several steps, up to the hardest JNU, JAM and GATE questions.
1 questionPractise →
Delhi School level
This topic’s hardest questions, from the DSE entrance, are worked through in Lesson 12: Definitions and set-ups that need care.
4 questionsLesson 12 →
All 7 past-paper questions for this lesson, easiest first: practise the full set →
These are questions from the TestStop bank. A free account answers 10 a day, each with its worked solution; All-Access opens every set with no daily limit.
Read next
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