What’s it: Demand shocks are unexpected disruptions to the demand for goods and services. It can be positive or negative disruption. Positive disruption increases aggregate demand and accelerates inflation, making the economy overheated. Negative disruption reduce aggregate demand, leading the economy to recession and deflation.
How demand shocks affect the economy
Surprise events lead to an increase or decrease in demand for goods or services. Government stimulus programs, high levels of consumer confidence, easy credit, economic expansion in key trading partners can increase aggregate demand. Conversely, a high increase in tax rates, tight credit, recession in trading partner countries can cause negative demand shocks.
Aggregate demand soars
High consumer confidence drives households to buy more products and services. As a result, the prices of products and services soared, pushing inflation up.
When inflation is high, it requires contractionary economic policies. Sharp price increases erode the purchasing power of money. If left untreated, it can cause distrust of the domestic currency, as in periods of hyperinflation.
The central bank can tighten its monetary policy. They can do this by raising policy rates, raising reserve requirement ratios or open market operations by selling government securities.
On the other hand, the government also can tighten fiscal policy. The government can choose to increase taxes or reduce spending.
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Both policies aim to reduce the rate of demand for goods and services. When interest rates rise, for example, borrowing costs become more expensive — the increase disincentives for households to buy products, especially credit-bought items such as cars.
Likewise, when taxes rise, household disposable income decreases. They have to pay more taxes, reducing the amount spent on the consumption of goods and services.
When it falls
Shocking effects such as the global economic recession can drop aggregate demand. As a result, the economy operates far below its potential level and can cause a recession.
To overcome that situation, the government adopted expansionary policies, both fiscal and monetary. Some options are:
- Lowering the policy rate
- Lower the reserve requirement ratio
- Open market operations by buying government securities
- Increase government spending
- Reducing tax rates
All of these options seek to drive aggregate demand. When aggregate demand increases, the business will respond by increasing production. They then order capital goods and recruit new workers. As a result, real GDP grows stronger and unemployment falls.
What to read next
- Aggregate Demand Curve: Meaning, Sloping Reasons, Determinants
- Aggregate Demand: Formula, Components and Determinants
- Business Confidence: Its Effect on Aggregate Demand and the Economy
- Capacity Utilization: Its Relationship With Profitability, Aggregate Demand and the Economy
- Consumer Confidence: Its Effect on Aggregate Demand and the Economy
- Demand Shock: Definition and a Brief Explanation
- How Exchange Rates Affect Aggregate Demand and the Economy
- How Fiscal Policy Affects Aggregate Demand and the Economy
- How Household Wealth Affects Aggregate Demand and the Economy
- How Monetary Policy Works Affects Aggregate Demand and the Economy
- Supply Shock: Examples, Causes, Effects
- Economic Shock: Types, Causes, Impacts
- Adverse Economic Shocks: Examples, Impacts, Solutions
- Macroeconomic Equilibrium: Short Run Vs. Long Run
- Aggregate Supply: Meaning, Determinants