Economic Shocks: Disrupting Growth and Stability [Causes and Impacts]

What’s it: An economic shock is a sudden and unexpected significant change in an economy’s output due to changes in external factors. Shocks suddenly cause the aggregate supply curve or demand curve to shift to the right or left. Such events not only impact aggregate output and, therefore, economic growth. But, it also broadly impacts the economy and affects the inflation and unemployment rates.

Shocks can be positive or negative. For example, a positive supply shock increases aggregate output and shifts the short-run aggregate supply curve to the right. Conversely, a negative supply shock causes aggregate output to fall, shifting the short-run aggregate supply curve to the left.

The Covid-19 pandemic is an example of recent economic shocks. The spike in oil prices is another example.

In general, shocks are caused by changes in aggregate demand and supply determinants. But, unlike normal changes, shocks are sudden and have a dramatic impact. As a result, the economy is inadequate in responding to it, possibly causing panic.

What are the types of economic shock?

Shocks can be of many different types. For example, if we categorize by source, we include supply shocks and demand shocks. Meanwhile, if we categorize based on the effect, we include positive shocks and negative shocks.

For example, if a negative shock occurs in aggregate supply, it decreases aggregate output suddenly. Meanwhile, aggregate demand shrinks if it happens on the demand side.

Supply shock

A supply shock causes aggregate output to change suddenly and unexpectedly. For example, an event like a natural disaster can cause aggregate output to fall significantly. On the other hand, a sharp drop in oil prices could result in a sharp increase in aggregate output as production costs drop dramatically.

Supply shocks are divided into two types based on their effects:

• Positive supply shock
• Negative supply shock

A positive supply shock causes aggregate output to increase and shifts the supply curve to the right. If it occurs in the short-run supply curve, the change causes the short-run macroeconomic equilibrium to move to the right. Assuming aggregate demand does not change, the shock results in an increase in aggregate output and a decrease in the price level (decreasing inflationary pressures). In addition, the unemployment rate also fell as businesses increased their output.

If the economy was operating at full employment (point A) before the shock occurred, the shock resulted in a positive output gap. Short-run equilibrium is reached to the right of the long-run aggregate supply curve (point D). As a result, real GDP exceeds potential GDP at the lower price level.

Meanwhile, a negative supply shock caused aggregate output to fall drastically, causing the short-run aggregate supply curve to shift to the left. As a result, aggregate output decreases, accompanied by an increase in the price level, assuming aggregate demand does not change. This situation could lead to a contraction or a recession. In addition, a decline in the price level may result in the inflation rate slowing down (disinflation) or even falling into the negative zone (deflation).

A leftward shift of the short-run aggregate supply curve leads to a negative output gap if, before the shock, the economy was operating at full employment. This is because the short-run equilibrium changes from point C to point B. As a result, real GDP is less than potential, leaving some economic resources unemployed and rising unemployment rates.

Demand shock

A demand shock causes the aggregate demand curve to shift to the right or left. A positive demand shock shifts the aggregate demand curve to the right. Conversely, a negative demand shock causes the aggregate demand curve to shift to the left.

Now assume the economy is at full capacity. A positive demand shock causes the economy to operate above full capacity because the aggregate demand curve shifts to the right (from AD0 to AD1). As a result, the economy produces more output (from potential GDP to GDP1) at a higher price level (from P2 to P0). In this situation, the economy experiences a positive gap where aggregate output exceeds potential output.

The positive gap is accompanied by an increasing inflation rate as the price level rises. In addition, the unemployment rate is low because the economy exceeds full employment.

Conversely, a negative demand shock results in a decrease in the demand for goods or services. As a result, aggregate demand falls and shifts its curve to the left, for example, from AD1 to AD0. If, before the shock, the economy was operating at full capacity at point A, a negative demand shock results in a decrease in output from potential GDP to GDP2, assuming the short-run aggregate supply curve does not shift (stays at SRAS1).

A shift from AD1 to AD0 results in a new equilibrium reaching point B. As a result, the economy is operating below its full capacity. The decrease in output from potential GDP to GDP2 is also accompanied by a decrease in the price level (from P1 to P0).

What factors cause economic shock?

In general, economic shocks occur due to sudden changes in external factors that cause dramatic changes in aggregate output or aggregate demand.

Supply shock

Rising oil prices are a good example of what causes a negative supply shock. It increases production costs as it is used in various industries. Thus, the increase forced businesses to cut their production. In addition, they also pass the rising costs onto the selling price, causing the prices of goods and services to rise. This situation leads to stagflation, in which aggregate output decreases, accompanied by an increase in the inflation rate.

In the graph, stagflation occurs when the short-run aggregate supply curve shifts to the upper left. Thus, if aggregate demand does not change, output falls (from potential GDP to GDP2), and the price level rises (P2 to P0).

In addition to rising oil prices, negative supply shocks can occur due to natural disasters. For example, floods and droughts result in crop failures and shocks.

A recent example is the COVID-19 pandemic. This caused difficulties in mobilizing goods and people and led to recessions in many countries.

War, like the war in Ukraine, is another example. It significantly reduces the world’s wheat supply because it involves the two major wheat-supplying countries in the international market.

In addition to these factors, negative shocks on the supply side can also occur due to:

• Significant increase in wages. Production costs increased dramatically and prompted businesses to cut production.
• Rise in raw material prices. Like rising wages, more expensive raw materials increase production costs and force businesses to cut output.
• High taxation means that the company has to pay more for each dollar it receives in tax.
• Elimination of subsidies. This increases costs, as happens when the government lifts energy subsidies.
• The sharp depreciation in exchange rates. As a result, the imports of raw materials and capital goods become more expensive. The impact can be significant if the business relies entirely on imports.
• Technology setback. This can dramatically impact the economy’s output and productive capacity, impacting both short-run and long-run aggregate supply.
• Trade war. This can significantly impact the importing country if it relies on supplies from partner countries. For example, the 2018 US-China trade war resulted in a shock in the supply chain.

On the other hand, a positive supply shock can occur because:

• Favorable climate, allowing the harvest to increase.
• A sharp drop in oil prices, lowering energy and transportation costs.
• Decrease in the wage rate; thus, the labor cost decreases.
• Cheaper raw materials, thus, lower input costs.
• Lower taxes, allowing businesses to have more retained earnings.
• Providing subsidies, thereby reducing production costs.
• An appreciation in the exchange rate, thus making imports of raw materials and capital goods more expensive.

Note: Changes in the factors above can only cause shocks if they occur suddenly and have a dramatic impact. Otherwise, it doesn’t count as a shock.

Demand shock

A negative demand shock results in a dramatic and sudden drop in aggregate demand. It happened because:

• Consumer confidence is falling, just like during a recession. They face deteriorating job and income prospects. As a result, they have to reduce consumption expenditure and save more.
• Global recession. As a result, exports fell due to reduced demand for domestic products. This can significantly impact if a country relies on exports to grow its economy.
• Tax increase. If the government increases taxes significantly, it reduces disposable income (if it is imposed on income) and makes prices more expensive (if it is imposed on goods and services). As a result, the demand for goods and services falls due to a decrease in disposable income or an increase in the price of goods and services.
• Increase in interest rates. Suppose the central bank raises interest rates aggressively. In that case, it increases borrowing costs, forcing households to delay spending on loans, such as on homes and cars.
• Wealth falls. For example, the asset bubble burst, causing household wealth to fall instantly. As a result, consumers reduce spending because their wealth disappears instantly.
• Trade war. If the government stops exports as a trade war implementation, it could cause a negative shock to aggregate demand.
• Exchange rate appreciation. A sharp appreciation in the exchange rate makes domestic goods more expensive for overseas buyers, which can cause exports to fall.

Then, if the above factors move in the opposite direction, it could lead to a positive demand shock. For example, an asset bubble increases household wealth, boosting demand for goods and services. In this situation, interest rate cuts amplify the impact of the asset bubble on consumption.

In short, positive shocks on the demand side result from:

• Strong consumer confidence
• Global economic expansion
• Dramatic tax cuts
• Sharp cut in interest rates
• Increase in wealth
• Exchange rate depreciation

As with supply shocks, changes in the above factors will lead to shocks if they cause sudden and dramatic changes in aggregate demand. Otherwise, we take it as a normal change.