Supply shocks and the divine coincidence

- Central banks face a trade-off between inflation and output variability.
- The conventional view is that supply shocks can create the trade-off.
- Yet no theory justifies the conventional view.
- This paper resolves the issue by focusing on low substitutability between inputs.

Unlike the conventional view, Blanchard and Gali (2007) point out that supply shocks alone do not create a policy trade-off between stabilizing inflation and stabilizing the output gap. This paper shows that supply shocks can be a natural source of the trade-off by assuming that non-produced inputs are used in fixed proportions with output in the production process. The results can also be generalized to the case when the elasticity of substitution between non-produced inputs and labor is less than unity.