Supply shocks and menu costs

Abstract

PurposeThe purpose of this paper is to examine how firms respond to adverse supply shocks.Design/methodology/approachThis paper examines a supply shock within the framework of Mankiw's Menu Cost Model.FindingsThe analysis in this paper illustrates that the type of adverse shock is important. An immediate increase in the money supply may work well in response to a negative aggregate demand shock, but be counter‐productive in response to a negative supply shock. This paper finds that output will decrease when the Federal Reserve increases the money supply in response to an adverse supply shock.Practical implicationsThe implication is that when the Federal Reserve first spots a negative supply shock (such as an increase in oil prices), it should not immediately respond with an increase in the money supply. Doing so might cause a recession.Originality/valueWhen there is a negative supply shock, conventional wisdom holds that an increase in money supply can offset the decrease in output that would occur without a policy response. That is, increases in money supply have the exact opposite influence that most economists often suppose.