The 1979 oil price shock reopened the debate about the proper response of aggregate demand policy to supply shocks. In the wake of the 1973 oil price increase, monetary policy turned restrictive in an attempt to "extinguish" the flare-up in inflation. Inflation was reduced, but the U.S. economy experienced its worst recession since World War II. The optimal policy response to any supply shock depends not only on social preferences about inflation and unemployment, but also on the institutional framework in which wages and prices are set. In particular, the scope for maintaining output and employment in the face of an oil price disturbance ("accommodating" instead of extinguishing the disturbance) depends on the flexibility of real wages and the real non-oil prices-that is, on the degree to which the oil price increase is this flexibility, a small econometric modelof wage and price behavior during the last fifteen years is estimated. The model includes some minor refinements to conventional techniques used to assess both the manner in which expectations of inflation are formed and the degree to which temporary oil price increases are incorporated into expectations of inflation. Simulations of the increase will not raise the trend rate of inflation, though it may appear to do so because of the long lags involved in pricing behavior, expectations formation, and wage determination. The model is also used to assess the impact on the incomes policies of the Carter administration, which were designed to promote real wage and price flexibility; simulations suggest that the pay and price standards had a modest effect on wages during the first program year. The authors conclude that the appropriate response to an oil price shock is an aggregate demand policy that aims at keeping the GNP gap relatively constant on its preshock trajectory. In the process of performing their analyses, they identify some of the major problems in addressing these important policy issues with the standard techniques.