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Market Upheaval: Influencing Trade and Investment Decisions [Exploring Triggers and Repercussions]
A supply shock is an unexpected event that significantly impacts the economy by causing a drastic change in output. This change can be positive (increased output) or negative (decreased output).
Supply shocks mostly refer to macroeconomic shocks that influence the aggregate supply in the economy and economic variables like economic growth, inflation rate, and unemployment rate. However, they can also refer to shocks within a specific market that affect the output and market price for a particular product, without affecting aggregate variables like real GDP or unemployment rate.
We distinguish supply shocks from gradual changes in supply because the former is sudden and impacts the market dramatically, causing panic in the short term.
Prepare to Learn the Types of Supply Shocks
Supply shocks fall into two categories based on their effect on output:
- Positive supply shock
- Negative supply shock
Positive Supply Shocks and Examples
In macroeconomics, positive supply shocks result in an increase in output. This happens because the supply curve shifts to the right, which leads to a sudden, positive output gap and a decrease in the price level.
Examples of positive supply shocks include the decline in oil prices, a decrease in union pressure, and a good harvest season. In addition, business tax cuts, subsidies, exchange rate appreciation, and technology advances can cause positive supply shocks.
Negative Supply Shocks and Examples
Negative supply shocks cause the economy's output to shrink drastically. These can occur due to several reasons, such as an increase in oil prices, a pandemic like COVID-19, or natural disasters like earthquakes or hurricanes.
Likewise, strong union pressure, war, and trade barriers can cause negative supply shocks.
Now it's Time to Learn How Supply Shocks Affect the Market and Economy
Shocks affect both output and market prices. Positive shocks lead to a drop in prices as supply increases drastically. Conversely, negative shocks result in a rise in prices as supply shrinks. However, the duration and severity of the shock will depend on how demand responds to the shift.
Inelastic demand indicates consumers are less responsive to price changes, meaning demand still remains strong, even though prices have risen sharply. Conversely, elastic demand suggests that a decrease in demand occurs as soon as prices spike due to the shrinking output.
Aggregate supply shocks cause sudden and dramatic changes in aggregate output. They impact economic growth, inflation rates, and unemployment rates.
A short-run positive shock leads to an increase in output, a lower price level, and a decrease in the unemployment rate. Meanwhile, a negative supply-side shock causes the economy's output to fall, an increase in inflation, and an increase in the unemployment rate.
Examples from History
The oil embargo by OPEC and the 1980s oil price hike are examples of how supply shocks can cause inflation and a decline in economic growth in the United States. In contrast, technological breakthroughs like the personal computer revolution in the 1980s and the internet boom in the late 1990s are instances of positive supply shocks that led to increased productivity, lower prices, and economic growth.
Bonus: Insight into Inelastic and Elastic Demand
Inelastic demand suggests that consumers are not very responsive to changes in the price level of a product. On the other hand, elastic demand means that consumers tend to react strongly to changes in price. Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price. Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price.
New Insights on the Workings of Supply Shocks:
- Technological breakthroughs can result in positive supply shocks that reduce production costs, lower prices, and increase economic output.
- The discovery of new resources can also lead to positive supply shocks by increasing resource availability and lowering production costs.
- Physical or human capital improvements can boost production capacity, leading to positive supply shocks.
- Natural disasters like hurricanes or droughts reduce resource availability and increase production costs, causing negative supply shocks.
- Supply chain disruptions such as tariffs or sudden restrictions on imports reduce supply and push up prices, resulting in negative supply shocks.
- A reduction in the labor force increases the natural rate of unemployment, which in turn lowers production capacity, resulting in negative supply shocks.
- Commodity shortages, like those experienced during the 1970s oil crisis, lead to higher prices and lower output, causing negative supply shocks.
