Demand shock
Demand shocks are certain events related to politics and other than changes in policy that have an impact on shifting the aggregate demand curve. Then the demand changes unexpectedly and rapidly. We distinguish between two types of demand shocks: positive (positive) and negative (negative). They are counted among economic shocks.
From time to time there are shocks in the economy (shocks) or distortions affecting economic dependencies that put the economy out of balance, and which may require policy response. Unpredictable events occurring in the economy are something ordinary. They are influenced by, for example: often inconsistent behavior of business people and the level of technical sophistication of the financial system. These disturbances may be temporary or permanent. It is difficult to distinguish them when they occur. Transient disturbances can be ignored because they will soon disappear.
The shock with respect to aggregate demand temporarily shuts the economy away from potential GDP and introduces it into a boom or recession. By gradually adjusting the price level, the economy finally returns to its normal state. The reason for the shocks are unexpected changes concerning, for example, fiscal and monetary policy of the state (mitigation or tightening), market participants' expectations about possible profits or revenues, increase in private or public expenses and changes in consumer preferences. Monetary and fiscal policy are important determinants affecting the shape and location of the aggregate demand curve.
Negative demand shock
It happens when there is a sharp drop in demand. As a consequence, the aggregate demand curve shifts to the left.
Consequences:
- A fall in GDP below the potential level,
- Lowering the price level (deflation),
- Drop in the interest rate,
- Short-term drop in supply,
- Increase in investment expenses.
The process of gradual adjustment will continue until real GDP returns to the potential level. Investments will increase exactly by the amount by which they initially decreased. The interest rate will be low enough to stimulate investment. During a long period, real GDP will return to normal level, but during the period of gradual price adjustment the economy will go through the recession and rise in unemployment.
Positive demand shock
It happens when there is a sharp increase in demand. Then the aggregate demand curve shifts to the right.
Consequences:
- Initial interest rate reduction,
- Increased investment, exports and consumption,
- Short-term increase in supply,
- GDP growth and prices (inflation), resulting in interest rate rise.
Through this process of gradual adjustment of prices, the economy will finally return to its normal state. However, earlier it will go through the inflation period and the heyday of economic activity.
Policy response to demand shocks
- Monetary or fiscal policy is able to compensate for the shock that affects the combined demand. The shift of aggregate demand to the outside or inside of the system may be reversed due to the policy in the opposite direction.
- In general, the stability of aggregate demand is something desirable. However, the majority of economists say that active politics could increase instability instead of compensating for it. Monetarists are even opposed to launching a policy to counteract shifts in aggregate demand.
- Other economists opposed to active politics believe that the policy of compensating for demand disruptions will have no impact on the Gross Domestic Product.
Demand shock and cyclical unemployment
The consequence of cyclical changes taking place in the economy is the demand shock connected with cyclical unemployment resulting from fluctuations in the productivity of the economy.
When the decline in demand for services and goods reduces the demand for labor, as a result of which the number of unemployed persons increases, while the number of vacancies decreases, we are dealing with a negative demand shock.
A negative demand shock, leading to an increase in unemployment, contributes to the process of depreciation of human capital. People who are just starting to enter the labor market find it difficult to find a job, consolidate knowledge and give them the chance to demonstrate their knowledge and professional skills. On the other hand, people who lost their jobs lose their acquired skills and professional qualifications over time. In addition, along with the rapid technological advancement, skills held by employees turn out to be outdated.All this reduces the human capital resources that the unemployed have, and thus the chance of finding a job decreases, which results in the unemployment rate remaining high.
Positive demand shock occurs at the time of economic recovery, when the demand for services and goods increases, which in turn has an impact on the increase in the number of vacancies, contributing to an increase in the number of working people and a drop in unemployment.
There may also be a structural shock on the market when the increase in vacancies is accompanied by an increase in the number of unemployed. This shock shows the low effectiveness of matches between the number of unemployed people and vacancies. The reason for the structural shock may be the modification of the production structure, which changes through the demand for new services and products, thus the business owners report a need for new employees with new skills and qualifications.
The demand-structural shock is a combination of the above-mentioned shocks. It comes to him when the change in the efficiency of the market is accompanied by a change in the relationship between the number of unemployed people and vacancies caused by economic activity
Examples of Demand shock
- Exogenous events such as wars, natural disasters, and health crises can cause a negative demand shock by reducing the amount of money available to households and businesses.
- Changes in fiscal policy, such as tax cuts or increases in government spending, can cause a positive demand shock.
- Shifts in consumer confidence, such as during recessions or periods of economic uncertainty, can cause a negative demand shock.
- Changes in the cost of borrowing, such as when the Federal Reserve raises or lowers interest rates, can cause a positive or negative demand shock.
- Changes in the cost of energy, such as when oil prices rise or fall significantly, can cause a positive or negative demand shock.
- A change in foreign exchange rates, such as when the value of the US dollar rises or falls relative to other currencies, can cause a positive or negative demand shock.
Advantages of Demand shock
Demand shocks can have a number of advantages. It can create a more efficient allocation of resources, as demand can be shifted in response to changes in supply. It can also provide incentives for businesses to innovate and develop new products and services to meet the changing demand. In addition, demand shocks can stimulate economic activity by increasing consumer spending and investment, as businesses react to changing demand. Finally, demand shocks can lead to greater competition in the market, as firms attempt to outcompete each other to meet the new demand. *All of these can lead to greater economic growth and prosperity.*
Limitations of Demand shock
- Demand shocks can have both positive and negative effects on an economy and its citizens, however, they can also have several limitations.
- One limitation of demand shocks is that they do not take into account the overall supply of goods and services in the economy. This can cause prices to go up or down too quickly, resulting in market instability.
- Another limitation of demand shocks is that they can be difficult to anticipate. This can lead to a lack of appropriate policy responses, resulting in further volatility and economic instability.
- A third limitation of demand shocks is that they often create uncertainty, which can lead to decreased consumer confidence and reduced levels of investment.
- Finally, demand shocks can lead to a redistribution of resources in an economy. This can result in winners and losers, which can be difficult for policymakers to address.
The following are other approaches related to understanding and predicting demand shocks:
- Monetary policy: Monetary policy consists of the actions taken by a central bank to influence the availability and cost of money and credit. It is used to counter the effects of demand shocks, including rising inflation and deflation.
- Fiscal policy: Fiscal policy is the use of government spending and taxation to influence the economy. It is used as a tool to implement macroeconomic policy changes, such as responding to a demand shock.
- Expectation effects: Expectation effects refer to the impact of expectations of future events on demand. When consumers and businesses expect demand to increase, they can spend more and invest more, leading to an increase in demand.
- Income effects: Income effects refer to the impact of changes in income on demand. When income increases, consumers can spend more, which leads to an increase in demand.
- Inflation effects: Inflation effects refer to the impact of changes in the price level on demand. When the price level increases, consumers can buy less with their money, leading to a decrease in demand.
In summary, there are several approaches to understanding and predicting demand shocks, including monetary policy, fiscal policy, expectation effects, income effects, and inflation effects. Each approach has its own implications on the macroeconomy and can be used to understand and predict changes in aggregate demand.
| Demand shock — recommended articles |
| Structural inflation — Galloping inflation — Crowding out effect — Damping effect — Austrian business cycle theory — Deflation gap — Economic situation — Global demand — Natural rate of unemployment |
References
- Begg, D. K. (1982). The rational expectations revolution in macroeconomics: theories and evidence. Johns Hopkins Univ Pr.
- Bryant, R. C. (1989). Macroeconomic policies in an interdependent world. International Monetary Fund.
