Macroeconomic policies in a global context

External shocks on an AD/AS diagram: a world energy price rise shifts SRAS left and gives stagflation; the dilemma between accommodating and tightening; fiscal, monetary, supply-side and exchange-rate responses; transfer pricing and the global minimum tax; inaccurate information, uncertainty and shocks no country controls. Through the Bank of England’s November 2026 rate rise.

A shock from abroad, and a rate rise at home.

On 5 November 2026 the Bank of England’s Monetary Policy Committee raised Bank Rate by 0.25 percentage points to 4%, by eight votes to one, with the dissenter wanting 4.25%. It was the first increase since August 2023. Consumer price inflation had risen to 3.5% in September, and the Bank’s staff projected it to reach about 5% by the middle of 2027 as higher energy prices worked through to other costs and prices. The cause was global: conflict in the Middle East had kept oil and gas prices high and volatile, Brent crude had been above $100 a barrel since September, and euro area inflation reached 4.0% in October.

The Bank said there was so far little evidence of significant second-round effects beyond energy itself, but that energy costs had been high for long enough that firms would start to pass them on and workers to seek compensation. Raising rates could not lower the price of gas; it could limit how far the shock spread into the general price level, at the cost of weaker demand in an economy whose productive potential the OBR already expected to grow only about 1% in 2027 because of the same energy prices. That trade-off, forced on a country by events it cannot control, is the subject of this lesson.

Source: Bank of England, Monetary Policy Summary and Monetary Policy Report, 5 November 2026; OBR, Economic and fiscal outlook, October 2026; Eurostat flash estimate, October 2026.

External shocks, the policy tools and their limits.

An external shock is an unexpected event originating outside the economy that moves output, prices or the balance of payments: a jump in world energy prices, a financial crisis abroad, a pandemic, a collapse in a trading partner’s demand, a swing in the exchange rate. In a globalised economy shocks arrive through trade, through capital flows and interest rates, through commodity prices and through confidence. A supply-side shock moves aggregate supply; a demand-side shock moves aggregate demand.

The policy response draws on the same four tools as ever: monetary policy (interest rates, quantitative easing), fiscal policy (taxes, spending, borrowing), supply-side policy (measures that raise capacity) and exchange-rate policy. Governments also try to control global companies: rules on transfer pricing, so profits are taxed where they are made rather than shifted to low-tax jurisdictions; the OECD global minimum corporation tax of 15%; and regulation of market power, labour standards and the environment. And policymakers face three permanent problems: inaccurate information (data arrive late and are revised), risk and uncertainty (the effect and timing of any policy are unknown), and the plain inability to control external shocks, which is what makes this a topic about judgement rather than technique.

Think first

On 5 November 2026 the Bank of England raised Bank Rate to 4%, its first increase since August 2023, with inflation at 3.5% and expected to reach about 5% by mid-2027.

The cause was a rise in world energy prices after conflict in the Middle East, not a boom at home. Higher interest rates cannot lower the price of gas. The Bank raised them anyway, by 8 votes to 1.

Why raise interest rates against a shock that comes from abroad?

An external supply shock raises prices and lowers output at once, and no demand-side policy can fix both. Accommodate it and inflation spreads; lean against it and the slowdown deepens. This lesson draws that dilemma and the tools on each side of it.

Step by step

1. The starting point. Aggregate demand AD1 and short-run aggregate supply SRAS1 meet at E1, output 500 and price level 100, on the vertical LRAS. No output gap, no pressure on prices. Everything that follows comes from outside: nothing in this economy’s own demand or supply changes until the shock arrives.

   Check: Before the shock the economy is at E1: output 500, price level 100, on LRAS. This means:

   E1 is the long-run equilibrium: AD and SRAS meet on LRAS. It is the position a shock disturbs.

2. The external shock. Dearer energy raises costs for every firm, so SRAS shifts left to SRAS2. Along the unchanged AD1 the economy slides to E2: output 400, price level 110. That is stagflation: inflation and a negative output gap at once, the signature of a supply shock. 1973, 2022 and 2026 all look like this. A demand shock could not produce it, which is how you tell the two apart.

   Check: World energy prices rise sharply. SRAS shifts left to SRAS2 and the economy moves to E2: output 400, price level 110. This is:

   Higher costs at every output level push the economy up and left along AD1. Prices and unemployment rise together.

3. The dilemma. Policy A accommodates: cut rates or loosen fiscal policy until AD2 restores output at E3, but the price level is now 120 and firms and workers learn that costs get passed on. Policy B leans against: tighten until AD3 brings the price level back to 100 at E4, with output at 300 and unemployment to match. Demand-side policy picks a point on SRAS2; it cannot move SRAS2 back.

   Teacher tip: Ask which policy the UK followed in 1973–75 and which in 2022–23. Accommodation ended with 25% inflation; tightening took Bank Rate to 5.25% and inflation from 11.1% to 2% by 2024, at the cost of two years of near-zero growth. November 2026 is a small step down the second road.

   Check: Policy A expands demand to AD2 until output is back at 500; policy B tightens demand to AD3 until the price level is back at 100. The outcomes are:

   With SRAS2 in place, every point available to a demand-side policy lies on SRAS2. The economy can choose where on it to sit, not whether.

4. In practice governments mix the tools. Fiscal policy cushions: in 2022 the Energy Price Guarantee capped bills at the taxpayer’s expense, so demand fell by less. Monetary policy restrains, as in November 2026, to stop the shock spreading. Supply-side policy, insulation, generation, storage, shifts SRAS2 back over years, not months. The exchange rate can help or hurt: a weaker pound makes imported energy dearer still.

   Check: Fiscal policy during an energy shock, such as the 2022 Energy Price Guarantee that capped typical household bills, is best described as:

   Support for bills shifts the burden from households to the state. It softens E2 without moving SRAS2, and it can pull against monetary policy.

5. The global part of the context. Firms move profits, capital and jobs across borders faster than governments can tax or regulate them. Transfer pricing rules require intra-group trades at arm’s-length prices; the OECD 15% minimum tax, in force in the UK from 2024, lets a home country top up tax on profit booked abroad. Both work only because many countries act together, which is also true of energy, finance and climate.

   Check: A multinational makes £200m of profit in the UK, where the corporation tax rate is 25%, but books it through a subsidiary in a jurisdiction charging 9% by overpricing services it sells to its UK arm. This is:

   Intra-group prices set above market rates move profit to low-tax places. The minimum tax tops the rate up to 15% wherever the profit is booked, so the saving shrinks from £32m to £20m on these figures.

What your diagram must show

• Axes labelled price level and real output, with LRAS at potential output
• AD1 and SRAS1 meeting on LRAS at the initial equilibrium
• SRAS shifted left after the energy price rise
• The new equilibrium at lower output and a higher price level
• AD shifted right by the policy response
• Output restored on LRAS at a higher price level still

A common mistake

The student drew the energy shock as a fall in aggregate demand, which lowers the price level to 90. A rise in energy prices is a cost shock: it shifts short-run aggregate supply left, so the price level rises while output falls. Real incomes do fall and demand may weaken later, but the first and defining effect is on the supply side. Drawing it as a demand shock predicts falling prices during an energy crisis, which is the opposite of 1973, 2022 and 2026.

Exam question

Evaluate the macroeconomic policy options available to a government and central bank facing a sharp rise in world energy prices.

Model answer

A sharp rise in world energy prices is an external supply shock. It raises costs for every firm, so short-run aggregate supply shifts left and the economy moves up and along aggregate demand to a point with a higher price level and lower output, on the diagram from output 500 and a price level of 100 to 400 and 110. That combination, stagflation, is what makes the policy choice hard: any demand-side response moves the economy along the new supply curve, so expanding demand restores output only at a price level of 120, and tightening restores the price level only at an output of 300. No domestic policy can move the supply curve back while the energy price stays high.

Monetary policy can lean against the shock to stop it spreading. That is what the Bank of England did on 5 November 2026, raising Bank Rate to 4% with inflation at 3.5% and projected to reach about 5% by mid-2027, on the argument that energy costs had been high long enough for firms and workers to start passing them on. The case for it is the 1970s, when accommodation of the oil shocks ended in 25% inflation; the case against is that higher rates cannot lower the price of gas, work with a lag of up to two years, and deepen the fall in output in an economy whose potential growth the OBR already put at about 1% for 2027. Fiscal policy can cushion the blow instead: the 2022 Energy Price Guarantee capped household bills so that real incomes and demand fell by less. But it is expensive, it keeps demand up while the central bank is trying to restrain it, and universal support subsidises households who did not need it, which is the argument for targeting. Supply-side responses, insulation, domestic generation and storage, are the only ones that shift SRAS back, and they take years. The exchange rate matters too: a weaker currency makes imported energy dearer still, which is one reason a central bank may raise rates even when the shock is external.

**However,** every option is chosen with poor information and against a shock the country does not control. The OBR revised its estimate of the 2026–27 output gap from −0.7% to −1.1% within seven months; the Bank described its own 5% inflation projection as highly uncertain and conditional on the Middle East; and the right policy depends above all on how long the energy price stays high, which nobody knows. A temporary shock is best looked through, since tightening would bite after it has passed; a persistent one must be leaned against before expectations shift. The same uncertainty applies to the global companies that transmit shocks and shift profits across borders: transfer-pricing rules and the 15% minimum tax work only because many countries act together, and coordination through the IMF, G20 or OECD is slow.

On balance there is no option that restores the economy to where it was. The defensible course is a combination: monetary policy that tolerates the first-round rise in prices but tightens, as in November 2026, once second-round effects threaten; targeted fiscal support for those who cannot absorb the bills; and supply-side investment that reduces the exposure to the next shock. The judgement is about which costs to accept, some inflation or some output, and for how long, and it should be made knowing that the data on which it rests will be revised.