Supply Shocks and Stagflation

On the AD-AS graph, a leftward shift of short-run aggregate supply means the same real GDP now comes with a higher price level, or the same price level now comes with less real GDP. Trace the new SRAS curve against a fixed AD curve: the intersection moves up and to the left. Price level rises. Output falls below potential. Unemployment climbs as firms produce less and lay off workers. That combination, inflation plus a shrinking economy, is stagflation.

A demand shift alone cannot do this. If AD moves while SRAS stays put, the economy slides along the existing SRAS curve, and price level and output move together: both up when AD rises, both down when AD falls. Only a shift of SRAS itself breaks that link and sends price and output in opposite directions. So stagflation is a signature of a supply-side disturbance, something that raises firms' costs or destroys productive capacity, not a demand-side one.

This is what makes supply shocks a genuine policy trap compared to demand shocks sitting elsewhere in the unit. A recessionary gap from weak demand has a clean fix: expand AD and both output and prices recover together. A supply shock offers no such clean fix. Expansionary policy that pushes AD back up closes the output gap but pushes prices even higher. Contractionary policy that fights inflation drags output down further and deepens unemployment. Whichever lever policymakers pull, they trade one problem for a worse version of the other.