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A surprise event that triggers an increase or decrease in demand for goods or services, either by a consumer or business, is known as a demand shock. Negative demand shock can begin with a global pandemic or natural disaster. A positive demand shock may start from an economic or government stimulus.
Key Takeaways
- Positive demand shocks increase aggregate demand in the economy.
- Negative demand shocks decrease aggregate demand as individuals save rather than consume.
- If a negative demand shock occurs, a government may counter it with a positive demand shock.
Positive Demand Shocks
Positive demand shocks increase aggregate demand in the economy, leading to increased consumption. Companies anticipating increased revenues may respond by hiring more workers or expanding operations. This increase in hiring and economic activity leads to further consumption.
A positive demand shock can lead to higher prices if the economy is near capacity, increasing the risk of inflation. Examples of positive demand shocks include:
World War II, the oil embargo of the 1970s, and the COVID-19 pandemic created demand shocks in the United States.
Negative Demand Shocks
Negative economic shocks often create fear. Individuals are more inclined to save rather than consume. They may be less inclined to take risks to start a business or pursue an education, activities integral to economic growth. On an aggregate basis, these individual decisions can lead to crippling economic losses.
To balance negative demand shock, governments may lower interest rates, cut taxes, or increase spending to reverse a negative spiral. This is intended to introduce a positive demand shock to counteract a negative one. Examples of negative demand shocks include:
- Global pandemics
- Terrorist attacks
- Natural disasters
- Stock market crashes
What Is a Supply Shock?
The opposite of demand shock, a supply shock increases or decreases output, affecting prices.
How Can a Positive Demand Shock Trigger Inflation?
A positive demand shock, such as interest rate cuts, makes borrowing money cheaper, and encourages consumer and business spending, but can boost prices. Lowering rates can lead to problems such as inflation and liquidity traps, which undermine the effectiveness of low rates.
What Is an Economic Shock?
An economic shock is any change to fundamental macroeconomic variables that affect macroeconomic outcomes and measures of economic performance, such as unemployment, consumption, and inflation. A demand shock is a type of economic shock.
The Bottom Line
Demand shocks can be positive or negative and result from a surprise event that triggers an increase or decrease in demand for goods or services. A demand shock is a type of economic shock that affects the aggregate economy.