To What Extent Do Supply Shocks Affect Inflation?

Abstract

This bachelor’s thesis will discuss the extent to which supply shocks affect inflation. This thesis is carried out as a literature review and is thus done by reviewing empirical results from various pieces of literature from around the world, with most literature studying the relationship using American data. Primarily this is done using the theory of aggregate supply curves, the Phillips curve, and shifts in these curves to represent supply shocks and studying their effect on inflation. The results of the literature review suggest that the effects of supply shocks on inflation are varying, and each piece of literature made their own additions or changes to the Phillips curve to depict the inflationary power of supply shocks more accurately. The inclusion of the sticky-price assumption, interaction between price-setters and inflation expectations were all substantial additions to the traditional model and were added across different pieces of literature. With these additions, the literature reviewed has found that large (in magnitude) supply shocks disproportionately affect inflation. The literature reviewed also found that inflation expectations are ‘shock- anchored’, thus emphasizing the point that shocks only create short term fluctuations in inflation and inflation returns to natural rates in the long-run. Other literature also found that supply shocks hold inflationary power in the long-run only when inflation was expected to remain high after a shock, thus further emphasizing the importance of including inflation expectations in the Phillips curve, and the monetary policy in place (as it affects expectations). With each new piece of literature reviewed, this thesis came to a more rounded conclusion of how supply shocks affect inflation using the theory of aggregate supply and the Phillips curve.