; on the supply side, there has been low spare capacity throughout the production chain in an environment of geopolitical tensions. even allowing that the price of oil has recently fallen back to below $ 60 a barrel, the rise in the price of oil from under $ 30 a barrel represents a very significant oil price shock. it has come at a time when both the us economy and that of the euro area have been experiencing diverging productivity developments. since the mid - 1990s, the us has experienced a positive productivity shock with the long - term trend in productivity having picked up significantly following twoand - a - half decades of downwardly trending productivity. by contrast, in the euro area, the downward trend that began in the 1970s has continued ( figure 3 ) 3. the responses of both the us and the euro area, in terms of inflation and output, to the oil price shock have, until now, been subdued. the us economy has continued to expand at a robust pace. while growth in the third quarter of this year was considerably below expectations, this outcome was primarily a reflection of the slowdown in housing ; whilst inflation rose to around 4 % this summer, it has subsequently subsided with the fed ’ s recent cycle of monetary tightening inter alia having contributed to this outcome. in the euro area, the recovery, while slow in getting under way, is now broadening and deepening. output this year is growing at close to, if not above, potential. moreover, inflation, while higher than the “ close to but below 2 % ” definition of price stability set by the ecb, is much below the levels experienced after the first two oil price shocks. these outcomes appear to be more modest than the predictions of econometric models, estimated on the basis of past relationships when oil - price shocks exerted a relatively large impact on inflation and growth. for example, euro area econometric models predict that a 50 % increase in oil prices, ceteris paribus, would add almost 0. 7 percentage point on average to cpi inflation in the first year, while reducing gdp growth by around 0. 4 percentage point ( table 1 ) 4. we have not, however, seen such large effects this time around. consequently, other factors appear to have worked to explain the actual outcomes following this particular shock. this argument can be elaborated on. in the us, the negative supply shock of the rise in oil prices has occurred at a time that the trend growth rate in productivity

a potential role for other economic policies? so far attention has concentrated on monetary policy responses to supply shocks. before concluding, it is useful to make a few remarks on the potential role for other economic policies. first, an economy ’ s tolerance of negative supply shocks will be enhanced if labour market flexibility is increased. this fact is something that is widely recognised and, in the eu, it has resulted in the adoption of various policies designed to reduce rigidities within the framework of the lisbon ecb ( 2006b ), p. 79. see gagnon, 1997. the idea underlying this argument is provided by woodford ( 2003 ). current inflation is a function of marginal cost ( including changes in oil prices ) and inflation expectations. if inflation expectations are well anchored they need not impact on current inflation during an oil price shock because market participants know that the central bank will take action to stabilize inflation. hence, the amount of actual monetary tightening will be less than that required by a less credible central bank because inflation will not have its own internal dynamic resulting from less - than - well anchored expectations. agreement. in the absence of central bank credibility, a monetary policy response to a negative supply shock is especially necessary because of the sluggish response of real wages to the shock. negative supply side shocks increase marginal costs ( either directly in the case of an oil price shock or through the need to employ more labour to produce the same output in the case of the negative productivity shock ). inflation in these contexts is the result of a lack of adjustment of real wages. thus the more quickly real wages adjust, the more quickly actual output will converge to the new potential output. if economies were more flexible, then the challenge for monetary policy posed by a negative supply shock would be much reduced19. second, if monetary policy is focused on price stability and anchoring inflationary expectations, the potential recessionary effects of a negative supply - side shock could be countered through fiscal policy. if fiscal conditions give governments the flexibility to let automatic stabilisers work following a negative supply shock, tax revenues will fall and transfers increase, stimulating the economy. moreover, a tight monetary policy that aims at countering the inflationary consequences of an adverse supply shock could be accompanied by a discretionary fiscal expansion, i. e. a reduction in tax rates or an increase in government spending. the latter policies might further contain the recessionary impact of the shock by offsetting the negative effect of the oil price rise on private demand. therefore,