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What’s it? An adverse economic shock is a sudden, unexpected, and dramatic change in aggregate supply and demand that hurts the economy. For example, shocks result in high and uncontrollable inflation or a recession. In other cases, they give rise to stagflation, where a recession and high inflation occur simultaneously. These three impacts are the main topics in this article.
By source, shocks arise from adverse supply shocks and adverse demand shocks. They occur due to changes in external factors, generally determinants of aggregate demand and supply. However, they are different from normal changes. Instead, shocks occur suddenly and have a dramatic impact on the economy.
Types of adverse economic shocks
The economic landscape isn’t always smooth sailing. Sudden disruptions called adverse economic shocks can throw things off balance. These shocks come in two main forms: supply shocks and demand shocks.
Adverse supply shocks: Imagine a scenario where something disrupts the ability to produce goods and services. This is an adverse supply shock. It can happen due to various factors, such as natural disasters (floods, earthquakes) that damage infrastructure and hinder production, leading to shortages.
Wars and political instability can also disrupt supply chains, limit access to resources, and increase production costs. Trade conflicts, with import restrictions, can raise the cost of imported goods and materials, impacting domestic production.
Adverse demand shocks: Adverse economic shocks can also come from a slump in spending, known as adverse demand shocks. These occur when something dampens consumer and business confidence, leading to a decrease in aggregate demand, the total amount of goods and services demanded in the economy.
Consumer confidence crises can erupt if people lose faith in the economy due to factors like job insecurity or falling wages. This translates to tightened belts and less spending. A global economic slowdown can also trigger an adverse demand shock. When the global economy weakens, demand for exports falls, impacting domestic production companies that rely on those exports.
Finally, sharp interest rate hikes by central banks can throw cold water on spending. Higher interest rates make borrowing more expensive, discouraging businesses from investing and consumers from making big purchases.
Understanding the adverse supply shock
An adverse supply shock occurs when the aggregate supply dramatically changes and has negative consequences. It is usually associated with negative shocks.
Negative shocks cause aggregate output to fall. At the same time, they also raise the price level (inflation soars), leading to what we call stagflation.
Conversely, a positive supply shock leads to an increase in output at a lower price level. This is considered favorable because the economy grows at a low inflation rate.
Factors causing adverse supply shocks
Disasters such as floods, earthquakes, and droughts cause negative supply shocks. They cause the output to fall. In addition, They also result in stuttering transportation, disrupting the supply chain.
The Covid-19 pandemic is a recent example. It has disrupted supply chains in many countries. It resulted in the collapse of the world economy, from 2.9% in 2019 to -3.1% in 2020.
In addition to disasters, adverse supply shocks also occur due to dramatic changes in:
- Wage increase
- Increase in oil price
- Sharp exchange rate depreciation
- Politics, like the war in Ukraine
The above factors are a shock if their change occurs suddenly and unexpectedly and dramatically affects a decline in aggregate supply. But, on the other hand, if their changes just took place normally, it wouldn’t be a shock.
For example, a moderate increase in the oil price may not cause a shock; it may only lead to a moderate increase in production costs. But if it rises sharply, a supply shock arises as production costs spike dramatically.
How adverse supply shocks cause stagflation
Take the dramatic rise in oil prices as an example. Oil is used in many industries, from plastics to transportation. So, its higher price increases the operating cost.
Rising production costs prompted businesses to cut their output. As a result, short-run aggregate supply falls, shifting its curve to the left (from SRAS0 to SRAS1).
Before the shock, the economy was operating at full employment (at point C). Thus, a leftward shift of the SRAS0 curve to SRAS1 causes the short-run equilibrium to be on the left (at point B), assuming aggregate demand does not change. As a result, aggregate output falls from potential GDP to GDP2. Meanwhile, the price level rises from P2 to So, long story short, the economy faces falling output and rising inflation. This situation is known as stagflation – a combination of the words “Stagnation” and “Inflation.”
The shock causes the short-run equilibrium to move from point C to point B. As a result, the economy operates below its potential output at the new short-run equilibrium. As a result, some economic resources are idle, leading to a higher unemployment rate.
The United States experienced stagflation in the 1970s. At that time, OPEC, especially members in the Arab region, declared an oil embargo against Western countries that backed Israel during the Yom Kippur War. This triggered an energy crisis, as oil prices jumped by 400%.
The oil crisis continued in the 1980s. The oil price jumped from about $15 a barrel in 1978 to about $37 a barrel in 1980. As a result, inflation in the United States nearly doubled. On the other hand, the United States’ real GDP contracted after a positive growth period.
Government policies to deal with adverse supply shocks
According to Neoclassical economists, the government should not intervene because the economy will return to its new equilibrium, called the self-adjustment process. A fall in the price level causes real wages to rise because nominal wages are rigid to fall. As a result, firms have the opportunity to cut nominal wages at a slower rate than the price level declines. Workers should, in theory, be willing to accept it because their real wages have not changed much.
Nominal wage cuts lower production costs, resulting in higher margins per unit for businesses. This situation encourages them to increase output, increasing aggregate output and returning the economy to long-run equilibrium.
In addition, the self-adjustment process goes hand in hand with the decline in oil prices. During high prices, oil producers face a decline in demand. As a result, weaker demand lowers oil prices over time. For the economy, falling oil prices push the short-run aggregate supply curve back to the right. And slowly, the economy is heading toward full employment.
The adjustment process can take a long time. For this reason, the government may prefer to introduce stricter policies to return the economy to its potential output. For example, the central bank lowers interest rates.
Lower interest rates encourage households to increase demand for goods and services. As a result, aggregate demand increases and shifts its curve to the right (from AD0 to AD1). And the economy returns to potential output but at a higher price level.
Higher inflation is certainly undesirable, which is why stagflation is a dilemma for governments and central banks. However, fiscal and monetary policy only impacts aggregate demand. Indeed, loose policies increase output and stimulate economic growth. However, they also cause inflation to rise higher. This is because the two policies do not address the core problem, namely aggregate supply-side shocks.
Understanding the adverse demand shock
Adverse demand shocks refer to sudden and dramatic changes in aggregate demand due to changes in external factors. They can be positive or negative.
Positive shocks cause aggregate demand to increase dramatically, leading to a sharp rise in inflation. This situation can harm the economy because the purchasing power of money decreases. Moreover, inflation can be uncontrollable and lead to hyperinflation, for example, through a wage-price spiral.
Negative shocks also hurt the economy. For example, a fall in aggregate demand can lead to a recession, which reduces the economy’s output. If it lasts long enough, it could lead to deflation, harming the economy.
Factors causing adverse demand shocks
Adverse demand shocks can occur because:
- Consumer confidence crisis
- Global economic recession
- A dramatic increase in taxes
- Sharp rise in interest rates
- Severe exchange rate appreciation
The above factors cause negative shocks, which lower aggregate demand. This situation could lead to a recession.
Then, if the above factors change in reverse, it causes a positive shock. As a result, aggregate demand increases. However, this situation can also produce other adverse effects, namely a sharp increase in inflation.
Remember: changes in the above factors cause a shock only if they cause aggregate demand to change suddenly and dramatically.
How adverse supply shocks cause a recession
Assume the economy is operating at the potential output at point A.
For example, the central bank raises interest rates aggressively. This policy makes borrowing costs more expensive, prompting consumers to cut consumption. Likewise, rising interest rates make investment costs more expensive, prompting them to cut capital spending. This situation eventually leads to a decline in aggregate demand.
A decrease in aggregate demand shifts the curve to the left (from AD1 to AD0). As a result, the economy’s output falls from potential GDP to GDP2 while the price level falls from P1 to P0. And the short-run equilibrium moves from point A to point B, assuming the short-run aggregate supply curve does not shift.
Because equilibrium is to the left of the long-run aggregate supply (LRAS) curve, the economy is operating below its full capacity. Some resources are idle. As a result, the unemployment rate rises, accompanying the decline in aggregate output.
If it lasts for a long time, the decline in the price level can lead to deflation, where the inflation rate is in the negative zone, for example, from 2% to -3 %. While it looks favorable, deflation—not only high inflation—is also harmful to the economy.
When deflation occurs, the prices of goods and services fall. This situation encourages consumers to postpone their current purchases to get lower prices in the future. Delayed purchases weaken demand further. Eventually, businesses cut production, causing output to fall further.
How adverse supply shocks lead to high inflation
Again, assume the economy is operating at the potential output but now at point C.
For example, the global economy grew strongly, causing exports to increase. Higher exports increase aggregate demand and shift the curve to the right, from AD0 to AD1. As a result, the short-run equilibrium moves from point C to point D, assuming the short-run aggregate supply remains unchanged.
As it goes to point D, aggregate output increases (from potential GDP to GDP1), accompanied by an increase in the price level (from P2 to P0). And the economy is operating above full capacity.
Because it operates above its potential output, the economy faces intense pressure on inflation. In addition, the unemployment rate falls, and the labor market becomes tighter. And a further decline in the unemployment rate will only lead to higher inflationary pressures.
If the situation is not addressed, inflation could rise to uncontrollable levels, harming the economy. For example, high inflation forces workers to negotiate higher wages to compensate for declining purchasing power. Finally, producers pass wage increases on to selling prices, causing inflation to rise even higher.
Higher rises in inflation again force workers to demand higher wages, driving up costs and, ultimately, pushing up selling prices. This situation continues and creates a wage-price spiral.
Spirals can cause inflation to spiral out of control. Soaring inflation can overheat the economy. To moderate inflationary pressures, the government usually launches tighter economic policies.
Government policies to deal with adverse demand shocks
When a recession persists due to a negative demand shock, the government will loosen fiscal policy to stimulate growth by:
- Increase expenditures
- Cut taxes
Meanwhile, on the monetary side, the central bank will adopt a loose monetary policy by:
- Cut interest rates
- Lower the reserve requirement ratio
- Open market operations by buying government securities
The policies above encourage aggregate demand to increase. For example, cutting interest rates encourages households to increase consumption expenditure.
Businesses then respond to this situation by increasing their output as they see stronger demand. They will invest in capital goods and recruit labor to increase output if they see strong demand. Eventually, more jobs and income are created in the economy, driving aggregate demand to increase further and shifting its curve to the right.
Meanwhile, to deal with positive shocks – which resulted in strong inflationary pressures – the government tightened fiscal policy by:
- Cut expenditures
- Raise taxes
Meanwhile, the central bank will adopt a tight monetary policy by:
- Raise interest rates
- Raise the reserve requirement ratio
- Open market operations by selling government securities
These two policies decrease aggregate demand and shift the curve to the left. As a result, inflationary pressures eased, accompanied by a decline in aggregate output.
How shocks impact investments
Adverse economic shocks can wreak havoc on the investment and capital market, impacting everything from stock prices to bond yields. Here’s a breakdown of how supply shocks and demand shocks play out in these markets:
Supply shocks
Supply shocks, which stem from production disruptions, pose a unique challenge for investors. On one hand, they can lead to stagflation, a situation where inflation rises while economic output falls. This can erode the value of stocks and bonds as inflation eats away at purchasing power and future returns. Moreover, companies may struggle to meet production quotas due to shortages, impacting their bottom lines and stock prices. However, it’s important to note that there are also potential opportunities during a supply shock, which we’ll explore further.
However, there are also potential opportunities during a supply shock. Companies in sectors less affected by the disruption, such as consumer staples (food, beverages, household goods), can see their stock prices rise as demand remains consistent. Additionally, commodities like gold and oil often act as hedges against inflation, meaning their prices tend to rise during inflationary periods. This can help offset losses in other parts of an investor’s portfolio.
Demand shocks
Adverse demand shocks, triggered by events like consumer confidence crises or global recessions, can have a chilling effect on the investment and capital market. As consumer and business spending dries up, companies across many sectors experience a decline in demand for their products and services. This translates to lower profits, potential job cuts, and, ultimately, a decline in stock prices.
During a demand shock, investors often gravitate towards ‘defensive sectors’ like healthcare, utilities, and consumer staples. These sectors tend to see relatively stable demand regardless of the economic climate, making them a safer haven for investments. Another strategy is value investing, which involves focusing on undervalued companies with strong fundamentals. These companies might be overlooked during a downturn, but their potential for future growth remains. Let’s explore these strategies in more detail.
Diversification and staying informed
No matter the type of shock, navigating economic turbulence requires a diversified investment portfolio. Spreading your investments across different asset classes and sectors helps mitigate risk.
Additionally, staying informed about potential economic shocks and their implications is crucial. By anticipating these events and adjusting your investment strategies accordingly, you can position yourself to weather the storm and potentially even capitalize on emerging opportunities.
