What’s it: An adverse economic shock is a sudden, unexpected, and dramatic change in aggregate supply and demand, hurting the economy. For example, shocks result in high and uncontrollable inflation. Or it causes a recession. In other cases, it gives 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. It occurs due to changes in external factors, generally determinants of aggregate demand and supply. Only, it was different from normal changes. Instead, shocks occur suddenly and have a dramatic impact on the economy.
What is an adverse supply shock?
An adverse supply shock occurs when aggregate supply changes dramatically and has negative consequences. Usually, it is identified with negative shocks.
Negative shocks cause aggregate output to fall. And at the same moment, it also causes the price level to rise (inflation soars). This situation leads 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.
What factors cause 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. That 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 do 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 which backed Israel during the Yom Kippur War. This triggered an energy crisis as oil prices jumped by 400%.
The oil crisis then 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.
How does the government intervene in the economy 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. As a result, businesses see higher margins per unit. This situation encourages them to increase output. As a result, aggregate output increases, 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. This is why stagflation is a dilemma for governments and central banks. However, fiscal policy and monetary policy only have an impact on aggregate demand. Indeed, loose policies increase output and stimulate economic growth. But, it also causes inflation to rise higher. This is because the two policies do not address the core problem, namely aggregate supply-side shocks.
What is an adverse demand shock?
Adverse demand shocks refer to sudden and dramatic changes in aggregate demand due to changes in external factors. It can be a positive or negative shock.
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 the economy into a recession in which the economy’s output falls. If it lasts long enough, it could lead to deflation, harming the economy.
What factors cause 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 do 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 arises, the prices of goods and services fall. This situation will encourage consumers to postpone their current purchases to get lower prices in the future. Delayed purchases weakened demand further. Eventually, businesses cut production, causing the output to fall further.
How do 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. And it harms the economy. For example, high inflation forces workers to negotiate higher wages to compensate for declining purchasing power. Finally, producers pass wage increases to selling prices. As a result, inflation rises 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. The economy is overheating because of soaring inflation. And to moderate inflationary pressures, the government will usually launch tighter economic policies.
How does the government intervene in the economy 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.
What to read next
- Demand Shock: Definition and a Brief Explanation
- Supply Shock: Examples, Causes, Effects
- Economic Shock: Types, Causes, Impacts
- Adverse Economic Shocks: Examples, Impacts, Solutions
- Macroeconomic Equilibrium: Short Run Vs. Long Run
- Aggregate Demand: Formula, Components and Determinants
- Aggregate Supply: Meaning, Determinants