Purpose – The purpose of this paper is to examine how firms respond to adverse supply shocks. Design/methodology/approach – This paper examines a supply shock within the framework of Mankiw's Menu Cost Model. Findings – The 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 implications – The 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/value – When 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.
