Supply Shocks, Wage Stickiness, and Accommodation

Abstract

The main issue discussed in the SUpply shock literature that followed the oil and food price shocks of the seventies was whether to accommodate.The supply shock reduces the equilibrium 1eel of output, and monetary policy cannot affect that.But in the seventies supply shocks were also followed by recessions.The question is whether monetary policy can and should be used to prevent such recessions.The paper analyzes the conditions under which a suppiy shock will result in.recession, and the potential for monetary policy to offset the fall in output.The basic result is that a pure supply 3hock need not result in a recession if the money stock is held constant.Aggregate demand effects associated with the supply shock--including the effects of monetary policy attempts to fight the inflation caused by the supply shock--may cause a recession, as also may real wage resistance by workers.The choice of polloy response to the supply shock then turns on the same basic issues as countercyclical policy in general, particularly the relative costs of inflation and unemployment.

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