At the risk of confusing the reader, this final chapter will be dedicated to illustrating some problematic and ambiguous cases with the help of the model as articulated over the previous chapters.

The problem, obviously, is that shocks never come singularly and are often of a complex nature with many and varied repercussions so that – at times – the policy reaction is ambiguous. At the time of writing (Spring 2023) the obvious examples to look into are the recovery from the Covid pandemic and the return of inflation after the Russian invasion of Ukraine in February 2022. The point to note is that these complex shocks cannot be constrained to be either a demand or a supply shock because there are major repercussions on both sides so that how to react to them is sometimes a major conundrum as far as policymakers are concerned.

The energy crisis

The rise in the price of energy is an example of such ambiguities. It may be envisaged that the price of energy would enter the specification of the Weintraub relationship in the component labelled R where the price of raw materials for production was factored in the pricing equation.

A rise in this price was represented already as a permanent negative shock to supply in Figure 1.7 so that potential output was lower than before (from ye to ye’) prompting the central bank to raise the interest rate in order to restore inflation to the target rate. However, for a country that is a net importer of energy the picture can be more complicated because the rise in energy price is also a negative demand shock. This is true for a number of reasons. First, in an open economy model the rise in the price of energy would indicate that the current account balance must show either a reduced surplus or a deeper deficit than before such a change occurred. On both accounts one can therefore imagine the open economy IS curve shifting left. But this can be justified also on the basis of energy being a necessary expenditure for consumers that are forced to cut back on other items. So on the basis of a drop in consumer confidence the IS curve can be imagined to be shifting left too. This is illustrated in Figure 10.1, which is effectively a modified rendition of Figure 1.7.