Stabilizing Aggregate Supply Shocks

Two types of shock occur to bring fluctuations in aggregate supply.

Productivity growth fluctuations.
The growth rate of productivity changes from time to time and therefore potential GDP (and the LAS curve) fluctuates.

Monetarist fixed rule with a productivity shock
A productivity growth slowdown decreases long-run aggregate supply. With a fixed rule, aggregate demand is unchanged. Real GDP decreases and the price level rises.

Feedback rules with productivity shock.

Real GDP stability conflicts with price stability in the face of a productivity shock. So there are two possible feedback rules.

1. Rule to stabilize real GDP. Suppose that the Fed's feedback rule is: when real GDP decreases, cut the interest rate to increase aggregate demand. This policy brings a rise in the price level but does not prevent the decrease in real GDP.
2. Rule to stabilize the price level. Suppose that the Fed's feedback rule is: when the price level rises, raise the interest rate to decrease aggregate demand. In this case, the price level is stable and real GDP is unaffected by the monetary policy.

When a productivity shock occurs, a feedback rule that targets the price level delivers a more stable price level and has no adverse effects on real GDP.

Fluctuations in cost-push pressure.
Cost-push pressures fluctuate and bring changes in short-run aggregate supply.

Monetarist fixed rule with a cost-push inflation shock

• If the Fed follows a monetarist fixed rule, it holds aggregate demand constant when a cost-push inflation shock occurs. Real GDP decreases and the price level rises - stagflation.
• There is a recessionary gap that eventually lowers the money wage rate and returns the economy to full employment. But this adjustment takes a long time.

Feedback Rules with Cost-Push Inflation Shock.
Again, there are two feedback rules.

1. Rule to stabilize real GDP. When a cost-push inflation shock occurs, the Fed cuts the interest rate and increases aggregate demand. The price level rises and real GDP returns to potential GDP. If the Fed keeps responding to repeated cost-push shocks in this way, a cost-push inflation takes hold.
   
2. Rule to stabilize the price level. A cost-push inflation shock leads the Fed to raise the interest rate and decreases aggregate demand. The Fed avoids cost-push inflation but at the cost of deep recession.