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6.5 Supply-side Shocks

Cyclical instability can arise because of shocks to aggregate demand or

shocks to aggregate supply, or some combination of the two. On the demand

side, the shocks may originate from instability in some component of the IS

curve, as stressed by Keynes and most of the earlier Keynesian models, or

they may originate from instability on the monetary side, as described by the

LM curve and emphasized by monetarists. On the supply side, we can imagine

a variety of shocks which could result in significant changes in productivity:

1. Unfavourable developments in the physical environment which adversely

affect agricultural output. This type of shock would include natural disasters

such as earthquakes, drought and floods.

2. Significant changes in the price of energy, such as the oil price ‘hikes’ of

1973 and 1979 and the subsequent reduction in 1986. James Hamilton

(1983, 1996) has argued that most US recessions since 1945 have been

preceded by energy price increases.

3. War, political upheaval, or labour unrest which disrupts the existing

performance and structure of the economy, as with the disruption experienced

in the former Yugoslavia and Soviet Union, and more recently in

Iraq, or the strikes and labour unrest in the UK during the 1970s and


4. Government regulations, such as import quotas, which damage incentives

and divert entrepreneurial talent towards rent-seeking activities.

5. Productivity shocks generated by changes in the quality of the capital

and labour inputs, new management practices, the development of new

products and the introduction of new techniques of production.

While some or all of the above will be important at specific points in time and

space, it is the fifth category, which we can broadly define as ‘technological

shocks’, which we can expect under normal circumstances to be the driving

force on the supply side over the longer term for advanced industrial economies.

It should not be forgotten that politically stable economies, which are

normally free from natural disasters, are still characterized by aggregate


Before examining the main features of REBCT we will first review the

main features and ‘stylized facts’ that characterize fluctuations in aggregate

economic activity (business cycles).