demand and supply-side shocks to an economy

Introduction to Economic Shocks

No country is immune to unexpected external economic shocks which cause fluctuations in national income, output and employment particularly those countries where a large and rising share of national output is linked directly to international trade in goods and services and inflows and outflows of foreign investment.

What is an Economic Shock?

Economic shocks cause unpredictable changes in aggregate demand and short run aggregate supply which lie outside our normal macroeconomic models. As a result of this a new equilibrium level of national output is achieved. The unpredictable nature of these shocks creates a fluctuating rate of economic growth and may require some sort of macroeconomic policy response. Nonetheless there are doubts about whether these shocks have any significant long-lasting impact on the health of individual economies and this raises questions about how much a government can and should do in order to mitigate the impact of an unplanned shock.

Demand Side Shocks for the Economy

(1) External Demand Shocks

An example of a demand shock, that is relevant to an open economy such as the UK, is a recession in a major trading partner such as the United States. If the United States is experiencing a recession, as happened in 2002 due to the collapse in share valuations, the slump in the ICT sector and the wider fall-out from the events of the 11th of September, real disposable incomes of US consumers will fall and hence demand for imports will fall. Britain exports around 15% of its total exports to the United States economy. Thus a recession many thousands of miles away can have an important impact on our trading performance. A fall in exports will (ceteris paribus) lead to a decline in aggregate demand for UK produced goods and services which then has further effects as this demand shock works its way through the circular flow of income and spending.

Some people might argue that because the UK has not entered recession international events have not had a great effect on economic growth. This is not true the UK has suffered due to the global downturn but this has, to some extent, been offset by continued strong levels of consumer confidence the reflationary effects of the decision by the Monetary Policy Committee to reduce nominal interest rates still further to their current level of just 4.0%. Cheaper money has been a key factor sustaining both confidence and consumer spending. The continued strength of house prices and low unemployment also helped to limit the impact of the demand shock that hit the British economy in late 2000 and through most of 2001. As a result aggregate demand has continued to grow, albeit at a reduced rate, and the economic downturn appears relatively shallow when we consider Britain's most recent economic growth statistics.

Data from the Office of National Statistics up to and including the second quarter of 2002 finds that real national output (real GDP) was rising at an annual rate of just 1.2% in the 2nd quarter of the year compared with a growth rate of 2.1% at the same time last year. Exports and capital investment spending are currently the weakest components of aggregate demand with exports declining by 2.7% year-on-year and capital investment spending 5.4% down on a year ago when measured in real terms. In reality, only consumer spending and government spending are keeping the economy away from recession's door with real household spending 3.9% higher year-on-year and general government spending 4.2% higher.

	COMPONENTS OF AGGREGATE DEMAND - £billion, at constant 1995 prices
	Households	NPISH	General Government	Gross Fixed Capital Spending	Change in inventories	Exports	Imports	Real GDP
1998	496.2	18.3	145.0	148.3	4.8	245.8	272.9	785.8
1999	519.2	18.2	149.4	149.1	6.3	258.9	296.7	804.7
2000	545.8	19.5	152.5	152.0	6.0	285.1	331.4	829.5
2001	567.9	20.4	155.9	151.3	0.4	289.2	340.3	845.6

The effects of the global slowdown last year were mitigated in part by cuts in official interest rates - central banks were able to cut interest rates because in most industrialized countries, the threat of inflation remained low - indeed interest rate cuts were judged necessary because of the growing threat of deflation.

(2) Domestic Demand Shocks

Demand shocks can also be caused by domestic shocks. A fall in domestic demand could be caused by a significant fall in house prices as was seen in 1989 in the UK resulting in the 1990-91 recession. The fall in aggregate demand was brought about by the reverse wealth effect forcing consumers to cut back expenditure and poor macroeconomic policy leading to high inflation and high interest rates resulting in a collapse in investment. The fall in output had two further affects. It led to a fall in the demand for labour and hence a rise in unemployment resulting in a fall in average disposable income. The result was a further fall in real consumer spending thus exaggerating the original fall in demand. This is known as the multiplier effect. The negative demand shock also had the effect of creating a negative output gap and hence causing a collapse in investment. Planned capital investment demand is normally positively correlated to the rate of economic growth if growth falls investment will fall exaggerating the initial fall in growth. This is known as the accelerator effect.

Demand side shocks have a general effect on real national income, but it is important to recognise that the impact will vary across regions and different industries. Because British manufacturing industry exports over half of what it produces, the negative consequences of a global downturn are felt most in the industrial sector. Our manufacturing industry has in deep recession throughout 2001 and although there have been tentative signs of a rebound in output in the summer of 2002, the manufacturing sector remains firmly in the grip of recession as the chart below indicates

Supply-side Shocks for the Economy

Supply side shocks cause cyclical instability by shifting short-run aggregate supply (SRAS) although they are unlikely to have any major impact on the long-run productive potential of the economy. A negative supply-side shock might be caused by a rise in world oil prices - over the last thirty years there have been several occasions when the international price of crude oil has moved sharply higher causing major effects on the economies of countries across the global economy. The rise in oil prices has causes an increase in the variable costs of firms for whom oil is an essential input into the production process. For this reason firms may seek to raise their prices to protect their profit margins. This will cause demand to contract and if the rise in oil costs affects sufficient industries across the economy, hence real national output will fall. A supply-side shock such as this has an inflationary effect on the general price level but a deflationary effect on real output.

The final magnitude of the effect of a supply side shock is dependent on the price elasticity of aggregate demand. If demand is inelastic firms will be able to raise prices and only a small drop in national output will be observed accompanied with a large rise in inflation. If demand is elastic firms will face a large fall in output if they decide to raise prices. The wider impact of a supply-side shock is similarly dependent on how producers and consumers respond to changing economic circumstances.

Clearly international shocks affect different economies in different ways. For example an economy that was dominated by manufacturing, and hence was dependent on oil, would be worse off than a service dominated economy or where the oil-energy requirements per unit of output produced is lower. Likewise if the economy has a flexible labour market and firms are able to cut costs by reducing real wages or successful in raising labour productivity (the effect of which should be to reduce unit labour costs) the effect of the oil-price shock will be reduced (but not eliminated). It is also important to note that a positive demand side shock could offset a negative supply side shock (although there would be upward pressure on inflation) so it is not always easy to see the full effect of a shock as many factors may be changing simultaneously.

The evidence for the British economy is that recent fluctuations in international oil prices have not really shaken the economy away from a period of sustained economic growth combined with low inflation. The UK is both an exporter and importer of oil and our long-term dependency on oil has fallen, not least because of structural changes in the economy (including the shift away from manufacturing towards services) and the beneficial impact of technological change.

Shocks and Government Macro-Economic Policy

The presence of demand and supply side shocks raises the question of whether monetary and/or fiscal policy should be used to actively manage aggregate demand and maintain macroeconomic equilibrium. There is always a tendency for policy to respond to shocks - for example when there is a negative demand shock caused by a global economic downturn, monetary policy can be relaxed through lower interest rates to sustain confidence and spending and prevent a collapse in output and employment. This was certainly the response of central banks around the world last year in the wake of a synchronized slowdown across the main industrialized economies.

Fiscal Policy in the United States

In the United States, the Bush administration responded to the US recession with an emergency programme of increased government spending and tax cuts - the classic example of using fiscal policy to stabilize aggregate demand. But there are already fears that this strategy risks unbalancing the United States economy in the longer term when the ripple effects of the recent recession have worked their way through the system. The Chairman of the US Federal Reserve, Alan Greenspan cautioned the US government recently about their fiscal policies. Greenspan was quoted as saying ""Returning to a fiscal climate of continuous large deficits would risk returning to an era of high interest rates, low levels of investment and slower growth of productivity." Official projections from the US government forecast that the US federal government will end the current year with a budget deficit of $165bn (£106.3bn) - and the risk is that a return to huge deficits will lead to an unsustainable growth in US government debt and the prospect of higher taxes in the future.

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