Supply Shocks in Macroeconomics

Abstract

The decade of the 1970s saw a resurgence of interest in the influence of the supply side on macroeconomic phenomena. The new attention paid to the supply side was driven by two major factors. First, the world economy faced a series of major supply-side shocks. These shocks lead to a breakdown of major relationships embodied in macroeconomic models. Second, the new classical macroeconomics brought about a reconsideration of the Keynesian emphasis on the demand side. The breakdown of the relationships in the Keynesian models would have been predicted by the new classical economists. These relationships were often based on historical correlations that could shift when the nature of the underlying shocks facing the economy changed. Keynes emphasized the role of effective demand in business cycle fluctuations. Following Keynes, much macroeconomic analysis neglected the role of the supply side. In periods when shocks to supply are minimal doing so will provide an adequate, if incomplete, understanding of economic fluctuations. The emphasis on effective demand proved inadequate for forecasting, analysis, and policy prescription in the face of supply shocks of the 1970s.