Alternative Responses of Policy to External Supply Shocks.

This article analyzes the policy issues posed by an inflation initiated by commodity shortages in the U.S. during the 1970s. For any given supply of farm products, an increase in nonfarm output raises the demand for farm products, and hence the relative price, by an amount that depends positively on the income elasticity and negatively on the price elasticity. The relative price depends, in part, on the level of nonfarm output, except in the special case of a zero income elasticity. Nonfarm output is assumed to be produced with labor and some other fixed factor, like capital. If a lower real wage causes workers to reduce their labor input, either by withdrawing from the labor force or by working fewer hours per week a crop failure must reduce nonfarm output. Whether or not the labor supply shrinks in the flexible-price case, the welfare of nonfarm workers is reduced. Not only does a crop failure reduce total real output, but also, as long as the demand for farm products id price inelastic, it transfers income from workers to farmers, who enjoy a windfall. In the case of perfect price flexibility, nonfarm output is either fixed or determined by workers' decisions about labor policy, leaving the nonfarm price level to be determined by stabilization policy. If, on the other hand, the nonfarm wage rate is rigid and nonfarm prices are marked up over the wage rate by a constant fraction, then nonfarm prices are fixed and nonfarm real output is determined by stabilization policy.