An Energy Shock, Two Boardroom Camps
In 2024 the economy of Marland is hit by a 60 percent jump in imported energy prices. Twelve-month headline CPI inflation is 6.4 percent; core inflation, excluding food and energy, is 2.9 percent. Real GDP growth has fallen from 2.6 percent to 0.7 percent, and unemployment has risen from 4.1 percent to 5.6 percent against an estimated natural rate of 4.5 percent. Wage growth is 5.2 percent and productivity growth is 1.0 percent. Survey measures of long-run inflation expectations sit at 2.3 percent, close to the central bank's 2 percent target, but one-year household expectations have jumped to 5.1 percent. The central bank has a dual mandate. One board member wants to raise the policy rate by 200 basis points immediately; another wants to cut, arguing that unemployment is already above the natural rate and the shock is imported, not caused by domestic demand.
1. Use aggregate demand and aggregate supply to characterize the shock, its short-run effects on output, prices, and unemployment, and what would happen in the long run without any policy response.
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The shock hits supply. Higher imported energy prices raise production costs at every level of output, shifting short-run aggregate supply left. The price level rises and real output falls; because firms need fewer workers to produce less, unemployment rises. Rising prices together with rising unemployment is stagflation, and it is exactly the combination that a demand-side expansion would worsen on the inflation side.
Headline versus core. The 6.4 percent headline figure is dominated by the energy component. Core at 2.9 percent is the better read on whether the shock is becoming general: so far, pass-through into wages and other prices is limited, though the 5.2 percent wage growth against 1.0 percent productivity growth is a warning sign.
Long run without policy. The leftward supply shift is not permanent in the same form. Once energy prices stop rising, the one-time level increase drops out of the twelve-month inflation rate. In the textbook long run, high unemployment pushes wages down, the short-run supply curve drifts back right, and output returns to potential with the price level higher. The danger is that the adjustment is slow and that workers, seeing 6.4 percent inflation, bargain for wages that keep costs rising, shifting supply further left and turning a one-time price jump into persistent inflation.
2. Evaluate the two proposals using the short-run Phillips curve, the role of expectations, and the concept of the sacrifice ratio.
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The case for tightening. Unemployment at 5.6 percent says demand is weak, but inflation is three times target and one-year expectations have already jumped to 5.1 percent. Monetary policy cannot create energy, but it can determine whether the shock becomes embedded. If expectations de-anchor, the short-run Phillips curve shifts up, and restoring 2 percent inflation later requires a much larger output loss. With a sacrifice ratio of roughly 2.5, each percentage point of disinflation costs about 2.5 percent of a year's output - cheaper now than after expectations move.
The case for easing. The economy is already below potential: Okun's law with a coefficient of 2 implies an output gap near −2.2 percent. The inflation is imported, so higher interest rates cannot reduce the price of oil; they only depress domestic demand and raise unemployment further. Rate cuts would support employment and reduce the risk of a sharp downturn.
Judgement. The decisive consideration is expectations. Long-run expectations are still anchored at 2.3 percent, which argues against a 200-basis-point panic move, but one-year expectations at 5.1 percent and wage growth well above productivity argue strongly against cutting. A middle path - holding rates, communicating forcefully that the central bank will not accommodate a wage-price spiral, and watching core inflation and unit labor costs - dominates both extremes. Easing now would repeat the mistake of the 1970s, when accommodating supply shocks produced a lasting inflation regime and a far larger eventual recession.
3. A board member asks whether the higher unemployment is cyclical or structural. Explain how you would frame the answer and why the distinction changes the policy prescription.
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Framing it. The 1.1-point rise above the natural rate looks cyclical on its face, but the energy shock can also raise the natural rate temporarily. If energy-intensive industries shrink and the workers they release lack the skills for the sectors that expand, mismatch unemployment appears that demand stimulus cannot cure. So the first step is to look at the composition of the unemployed - by industry, duration, and vacancy-to-unemployment ratios in specific labor markets - rather than only at the aggregate rate.
Why it matters. If the rise is cyclical, expansionary policy can close the gap and unemployment returns to 4.5 percent with little inflation cost. If the natural rate has itself risen to, say, 5.2 percent, then 5.6 percent is almost full employment, and stimulating toward 4.5 percent would generate accelerating inflation without much employment gain. In that case the correct tools are retraining, relocation support, and time, not interest-rate cuts.
Practical rule. Treat the natural rate as an estimate with a wide confidence band, not a fact. Watch whether wage growth is decelerating as unemployment rises - a sign the gap is genuine - and whether vacancies in expanding sectors go unfilled despite high unemployment - a sign of mismatch. The answer determines whether the central bank should target 4.5 percent unemployment or accept a higher sustainable rate.