Many economists consider an oil price shock to be illustrative of a classic supply shock that reduces output. Elevated energy prices are a manifestation of increased scarcity of energy, which is a basic input to production. With reduced inputs with which to work, output and labor productivity are reduced. (In more mild cases, the growth of output and productivity are slowed.) In turn, the decline in productivity growth reduces real wage growth and increases the unemployment rate.
If consumers expect such a rise in oil prices to be temporary, or if they expect the short-term effects of output to be greater than the long-term effects, they will attempt to smooth their consumption by saving less or borrowing more. These actions boost the real interest rate. With reduced output and a higher real interest rate, the demand for real cash balances declines and the price level increases (for a given rate of growth in the monetary aggregate). Therefore, higher oil prices reduce real GDP, boost real interest rates, and increase the price level (Table I). The expected consequences of a classic supply shock are consistent with the historical record.