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.