Oil price shocks lead to large adverse supply shocks in the macroeconomy, infer Dornbusch et al (2008) who define an adverse supply shock as; ‘one that shifts the aggregate supply curve upwards' (Dornbusch et al 2008, pp137). Theyreason that an increase in the oil price raises the cost of production for firms in the economy, which proceeds to increase the price at which firms are willing to sell their product.

Figure. A graph showing the effects of an adverse supply shock on output and price: (Dornbusch et al (pp138, 2008).

The graph in Fig. 2.1.1 illustrates an adverse supply shock. Firms curtail their supply in order to charge a higher price, therefore AS shifts upwards to AS*, impacting on the level of output, reducing from Y0 to Y1, which leads to an increase in the price, shifting from P0 to P1. If price level in an economy rises, this will induce a higher level of inflation, which is an undesirable result of the adverse supply shock.

Mankiw (2010) provides the same economic theory and provides further explanations noting that if such an adverse supply shock was to impact upon any economy then there are two different approaches which policymakers are able to adopt. Firstly, they can look to hold aggregate demand constant. If they were to implement this approach, then it is likely that the economy would be steered into recessionary periods of high unemployment and lower economic growth. However, prices will eventually fall to the original level prior to the shock which will re-establish previous levels of employment. The alternative approach for policymakers would be to raise aggregate demand in the economy which in turn will enable the economy to revert back to its natural level of output more swiftly than in the previous approach.The quickest way of stimulating aggregate demand is to lower interest rates, in order to incentivise spending in the economy by consumers and also to raise the level of business investment.