What is meant by a shock to aggregate supply How can economic policy Essay

What is meant by a shock to aggregate supply How can economic policy be implemented to counter such a shock - Essay Example The role of aggregate supply has been extensively examined in the literature. In this context, it has been found that ‘aggregate supply relationship typically links inflation surprises with fluctuations in the output gap, while potential output, defined as the flexible-price equilibrium output, is exogenous; based on such construct, micro-based interest rules respond exclusively to fluctuations in the inflation rates and the output gaps’ (Razin et al., 2005, 179). In accordance with the above view, aggregate supply can represent a particular relationship, this of output gaps and inflation rates. In fact, because aggregate supply refers to the balance between products/ services and the prices in a specific market, it is very likely that the turbulences of inflation rates (as a consequence of instability in the ‘balance’ described above) could be also considered as directly related with aggregate supply. The above views can be also supported by the fact that the differences in inflation rates in a specific market are thought to be closely related with the instability in aggregate supply (among other reasons) in the above market. Indeed, the study of Razin et al. (2005, 184) led to the assumption that ‘inflation is primarily affected by: (1) economic slack, (2) expectations, (3) supply shocks, and (4) the inflation persistence; thus, inflation depends on inflation expectations, the output gap, the (log) difference between the actual and flexible-price investment, and the (log) difference between the actual and flexible-price stock of capital’. Because of the influence of aggregate supply on the inflation rates, it could be expected that a radical change (extremely severe instability appeared unexpectedly) in aggregate supply could lead to severe financial consequences for the market involved. The above described unexpected changes in the relationship