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What’s it? A supply shock is a sudden and unexpected event that causes a dramatic change in output. It can be positive or negative. It is positive if it increases output and negative if it decreases output.
Shocks here can refer to macroeconomic shocks, which affect aggregate supply in the economy and economic variables such as economic growth, inflation rate, and unemployment rate.
Alternatively, it refers to a shock in the market, where the effect is limited to a specific product market. It also affects the output and market price for the product. However, unlike macroeconomic shocks, it has no effect on the aggregate variables such as real GDP, inflation rate, and unemployment rate.
We distinguish shocks from gradual changes in supply. The former is sudden and has a dramatic impact, causing an inadequate market response in the short term and causing a period of panic. The second is normal with changes in the determinants.
What are the types of supply shocks?
Supply shocks fall into two categories based on their effect on output. They are:
- Positive supply shock
- Negative supply shock
Positive supply shocks and examples
In macroeconomics, a positive supply shock results in an increase in output, which causes the supply curve to shift to the right. Assuming demand remains unchanged, the economy faces a sudden positive output gap, pushing the price level down.
The drop in oil prices is an example. Since oil is used in most industries, from raw materials to fuel, its lower price reduces costs. As a result, the decline can lead to a dramatic increase in economic output.
Another example is a decrease in union pressure and a good harvest season. Basically, positive supply shocks are caused by factors such as:
- Wage drop
- Business tax cuts
- Subsidy
- Exchange rate appreciation
- Technology advances
Those factors all affect aggregate supply. And they can cause shocks if their sudden change lowers costs dramatically and prompts a sudden, drastic increase in output.
Say, before the shock occurred, the economy was operating at full employment. Thus, when a shock persists, it causes output to increase, and the economy faces a positive output gap in which real GDP exceeds potential GDP, assuming aggregate demand does not change. As a result, aggregate output increases, accompanied by a decrease in the price level.
Meanwhile, supply shocks in the market may differ slightly from shocks in the economy. That’s because it impacts production for a particular product, not output in aggregate. And in addition to the above factors, supply shocks in the market can occur due to:
- Barriers to entry weakened, prompting many new players to enter the market.
- Large-scale new entrants (such as multinational corporations), backed by strong investment capital, allow them to operate at a significant scale.
- Trade barriers fell drastically, prompting import supplies to flow into the domestic market.
- Large-scale investment, especially in industries with significant fixed costs, where it is as difficult to cancel the project once started as it was during the commodity boom.
Negative supply shocks and examples
A negative supply shock causes the economy’s output to shrink drastically. Shock can occur for several reasons. An increase in oil prices is a good example because it has far-reaching economic implications.
Another example is a pandemic like COVID-19. It has disrupted supply chains by restricting the mobility of goods and people. As a result, supply is disrupted, and many countries face recession.
Apart from rising oil prices and the pandemic, other factors causing negative supply shocks include:
- Natural disasters such as earthquakes, hurricanes, or droughts
- War, like the war in Ukraine
- Stronger union pressure
Meanwhile, the supply shock in the market, in addition to the above factors, could occur due to factors such as:
- Bankruptcy by dominant players in the industry. Or they close several production facilities at once. Thus, the market supply shrinks suddenly.
- Cartel. Players collude to cut output to raise market prices. Cartels in the world’s oil industry are a good example.
- Trade barriers. High tariffs or embargoes cause supply to decrease. It could come as a surprise to the domestic market if the market has been highly dependent on imported supplies.
How do supply shocks affect the market?
Shocks have implications for output and market prices. A positive shock leads to a drop in prices as supply increases drastically. Conversely, a negative shock results in a price increase as supply shrinks.
However, the length and significance of the shock will depend on how the demand responds. For example, a negative shock can cause output to fall and prices to soar if demand remains constant. And it will be even more significant if demand remains strong—because demand is inelastic—for some time.
Inelastic demand indicates consumers are less responsive to price changes. They are still willing to buy even though the price has risen sharply – perhaps because the item is essential to them. As a result, demand in the market has not decreased much, even though prices have risen.
Conversely, if demand is responsive, negative shocks may have a less acute impact on prices. For example, demand falls as soon as prices spike due to shrinking output. Because demand is elastic, the market moves to a new equilibrium rapidly.
Elastic demand indicates consumers are responsive to price changes. Thus, an increase in price causes demand to fall more significantly. For example, if the price increases by 5%, the quantity demanded falls by more than 5%. A decrease in demand causes prices to fall, offsetting the price increase due to a decrease in output.
How do supply shocks affect the economy?
Aggregate supply shocks result in sudden and dramatic changes in aggregate output. They can lead to an increase or a decrease in aggregate output. In addition to economic growth, these shocks also affect inflation and unemployment rates.
Positive supply shock effect
Assume the economy is operating at full employment. Thus, real GDP equals potential GDP.
A short-run positive shock causes the short-run aggregate supply curve to shift to the right. As a result, real GDP increases and exceeds potential GDP, resulting in a positive output gap. In this situation, businesses are operating well above their most efficient capacity. Therefore, assuming aggregate demand does not change, the aggregate output will increase at the lower price level.
Long story short, a positive shock in short-run aggregate supply will end in an increase in output, a lower price level, and a decrease in the unemployment rate.
Negative supply shock effect
A negative shock results in a decrease in aggregate output (from Y0 to Y1). Say the economy is operating at full employment. In other words, the short-run equilibrium is right on the long-run aggregate supply curve (the AD0 curve and the SRAS0 curve intersect on the LRAS curve).
A negative supply-side shock causes the short-run aggregate supply curve to shift to the left, from SRAS0 to SRAS1. As a result, aggregate output falls (to Y1) at the higher price level (P1). That results in a negative output gap (Y0 minus Y1), where real GDP (Y1) is less than the potential output (Y0). Thus, the economy is not only facing a decline in aggregate output. However, the economy also faces an increase in the inflation rate (from P0 to P1). Then, the unemployment rate also increased along with output cuts by companies.
The above situation resulted in stagflation (from the words “stagnation” and “inflation”), which occurred in the United States in the 1970s due to the oil embargo by OPEC. Then, it also happened in the 1980s. For example, in the 1980s, the oil price jumped from about $15 per barrel in 1978 to about $37 per barrel in 1980. As a result, inflation in the United States skyrocketed and nearly doubled. On the other hand, rising costs made the United States’ real GDP contract after the previous year’s positive growth.
So, how does the economy return to long-run equilibrium? Economists explain this through what is called the self-adjustment process. In the above case, over time, the oil price falls, pushing the short-run aggregate supply curve back to the right. Slowly, the economy is heading toward full employment.
However, this adjustment can take a long time. For example, if a price increase is due to war, it means waiting for the war to end and some extra time.
For that reason, the government may intervene to return the economy to equilibrium through expansionary fiscal policy. The central bank may also do so through expansionary monetary policy, such as by lowering interest rates.
Assume, fiscal policy does not change, but the central bank lowers interest rates to carry out expansionary monetary policy. A decrease in the interest rate increases aggregate demand and shifts its curve to the right, from AD0 to AD1. An increase in aggregate demand encourages businesses to increase their output and steers the economy toward full employment.
However, this decision has another negative effect: the price level rises further, from P1 to P2. Thus, an increase in aggregate output carries another cost: the inflation rate.
This is the reason why stagflation is often a dilemma for policymakers. Monetary and fiscal policies only affect aggregate demand. Thus, it is not the right remedy for stagflation because the problem comes from the supply side. As a result, tightening policies will only lead to higher inflation.
Supply shocks: ripples through markets and investments
Supply shocks, sudden disruptions to the production of goods and services, can send shockwaves through the financial world. Understanding how these events impact different asset classes empowers investors and economics students to navigate these volatile periods.
Positive supply shocks: a tailwind for some assets
A positive supply shock, like a technological breakthrough that lowers production costs, increases the overall output of the economy. This translates to:
- Lower prices: Increased supply drives prices down, benefiting consumers and potentially boosting demand for certain goods and services.
- Booming stocks: Companies experiencing cost reductions due to the shock see profit margins rise. This can make their stocks more attractive to investors seeking growth.
- Bond market caution: While lower prices ease inflationary pressures, central banks might still raise interest rates to prevent future inflation. This can lead to bond price declines.
Negative supply shocks: a market headwind
Negative supply shocks, such as natural disasters or trade wars, disrupt production and cause shortages. This scenario unfolds differently:
- Higher prices: Scarcity of goods pushes prices up, leading to inflation. Investors in inflation-protected assets like Treasury Inflation-Protected Securities (TIPS) might see some gains.
- Stock market volatility: Companies facing higher input costs due to the shock experience declining profit margins. This can lead to stock price declines across various sectors.
- Commodity boom: Commodities like oil, whose supply gets disrupted by a negative shock, can experience significant price increases, potentially benefiting investors in those specific assets.
Investment strategies to weather the storm
Investors can employ various strategies to manage risk and potentially profit from supply shocks:
- Diversification: Spreading investments across different asset classes (stocks, bonds, commodities) helps mitigate risk. A negative shock impacting one asset class might be offset by gains in another.
- Hedging: Investors can use financial instruments like option contracts to hedge against potential price fluctuations caused by supply shocks. This helps limit potential losses.
Sector rotation: By anticipating the impact of a supply shock on specific sectors (e.g., energy prices rising due to war), investors can shift their portfolios towards sectors likely to benefit (e.g., renewable energy).
