It is a type of economic shock that can impact the aggregate demand for goods and services.
To understand demand shock, an understanding of supply and demand is important. In economics, demand is the consumer's willingness to buy certain products or services at a specific price at a particular time. There is a downward-sloping relationship between prices and quantity demanded.
If prices increase, fewer people are willing to buy that product. And if prices decrease, quantity demand for that product would increase.
On the other hand, supply is the suppliers' willingness to offer certain products or services at a specific price and at a particular time. There is an upward-sloping relationship between prices and quantity supplied.
This means if the price increases, suppliers are willing to supply more. And if the price decreases, the quantity supplied would decrease.
The supply and demand curve intersect at the equilibrium point, where the quantity demanded and the amount supplied is equal for that price point. The equilibrium point sets the price.
For demand shock, most people work with aggregate demand. Aggregate demand is the total spending on goods and services in an economy.
Demand shock (DS) is an economic shock that can impact the aggregate demand for goods and services. It is an unexpected and sudden event that causes a temporary increase or decrease in the demand for goods or services.
A positive DS is when there is a temporary increase in demand. On the other hand, a negative DS is a temporary decrease in the demand for a good or service.
Note that positive or negative does not equate to good or bad, but rather an increase or decrease. Excessive increases and decreases can both be problematic.
In contrast to a DS is a supply shock. A supply shock is a sudden and temporary change in the supply of goods or services.
Understanding Demand Shock
Essentially, in economics, a shock is an event or outcome that occurs unexpectedly, which results in a positive or negative effect on the economy.
Thus, demand shocks are unpredictable and can originate due to various reasons. It can range from being due to government stimulus checks to as simple as a negative review or recall.
When an unexpected event occurs, it results in the movement of the demand curve. This means the curve has to shift, creating a new demand curve.
Movements along the curve are not demand shocks. Instead, this reflects a change in quantity demanded due to price changes, which is not a change in demand.
The following graph shows the difference between a change in quantity demanded and a change in demand.
While they are temporary, there is no timeline set in stone, and the duration of one can widely range. It can last a few days to weeks to even years, depending on the magnitude of the shock or event.
However, they are still said to be temporary because the economy is never stagnant, and demand is always changing.
Positive Demand Shock
It is a sudden and temporary increase in the demand for goods and services. This results in the movement of the demand curve, causing it to shift to the right. Meaning that there is an increase in the quantity demanded at every price point.
A positive DS usually stems from changes to the fiscal policy, including tax cuts or economic stimulus.
Some events that can result in a positive DS include:
- New technology
- Cuts in central bank rates
- Positive reviews
The following graph shows the effects on the demand curve after a positive DS.
Since a positive DS causes the curve to shift to the right, there are two consecutive effects given the supply curve does not shift:
- The equilibrium point moves to the right. This means that the price of the good or service increases because demand has increased, and consumers want more.
- As a result of the movement of the demand curve and increase in price, the quantity supplied increases. This is because suppliers are now willing to provide more of that good or service due to the price increase.
To put this into perspective, when the government cuts taxes or provides stimulus payments, the number of money individuals spend increases as they receive more or have to pay the government less.
An increase in disposable income can increase demand for goods, thus driving prices and quantity consumed up.
Negative Demand Shock
It is a sudden and temporary decrease in the demand for goods and services. This results in the movement of the demand curve, causing it to shift to the left. Meaning that there is a decrease in the quantity demanded at every price point.
Some events that can result in a negative DS include:
- Increases in taxes
- Increases in interest rates
- Increases in rates
- Natural disasters
- Negative reviews
The following graph shows the effects on the demand curve after a negative DS.
Since a negative DS causes the curve to shift to the left, there are two consecutive effects given the supply curve does not shift.
- The equilibrium point moves to the left this time. This means that the price of the good or service falls because demand has decreased, and consumers want less.
- As a result of the movement of the demand curve and decrease in price, the quantity supplied decreases. This is because suppliers are now unwilling to provide the same amount of a good or service due to the price decrease.
To put this into perspective, when the government increases taxes, the number of money individuals spend decreases, as they have to pay the government more. As a result, less disposable income decreases demand for goods, thus driving prices and quantity consumed down.
Another example of a negative demand shock, most likely to be short-term, is a product recall. When products are recalled, their demand decreases as people may hesitate to buy them.
After a while, when the recall has been resolved, demand for the product will return to normal levels. This can be seen with romaine lettuce and many other foods.
When a recall has been issued for romaine lettuce, individuals have halted their purchasing until they feel it is safe or the recall has been dealt with. Consumers take cautionary measures but ultimately return to purchasing the item as it is a standard item.
Dealing with Demand Shock
While demand shocks can regulate themselves, sometimes government intervention is needed. To deal with them, the government can try to increase or decrease demand.
For instance, if there had been a negative DS, the government would take measures to increase aggregate demand. Thus, to counteract a negative DS, the government could lower interest rates, reducing the cost of borrowing and lending to more consumption.
This is what the Federal Reserve System did to fight the negative DS during the financial crisis of 2008.
The government may intervene in a positive DS as they do not want to give way to uncontrollable inflation.
To contain a positive DS, the government can increase interest rates or raise taxes, increasing the cost of borrowing and buying. This way, consumers will spend more conservatively and decrease aggregate demand.
Essentially, the government tries to bring about a positive DS to counter the effects of a negative DS and vice versa.
There are many examples of positive and negative DS in the world. For example, a recent demand shock that affected supply and demand on a global scale was the COVID-19 pandemic.
The global pandemic resulted in an overall negative DS, but there are also some aspects of a positive DS for certain goods. For instance, the pandemic caused a sudden increase in the demand for sanitary products like hand sanitizer, cleaning supplies, and masks.
However, the pandemic most notably caused a negative DS, especially in the service sectors. People not going to restaurants due to lockdown measures as a way to contain the spread all lead to a negative DS.
Furthermore, the loss of jobs in the service sector and other sectors due to the pandemic also decreased aggregate demand, thus contributing to the negative DS. As people lost their jobs and had reduced income, they were more conservative in spending.
Many governments undertook certain policies to boost consumption and stop the negative DS.
For instance, the provincial government of Ontario, Canada, introduced stimulus checks to individuals unable to work due to the pandemic. This was introduced to encourage spending and help citizens get through the tough period.
Another example could be the publication of medical journals and studies. For example, if a journal reports that a certain type of sunscreen can cause health issues, that would result in a negative shock.
There would be a sudden shift in demand as people consume that sunscreen less after being made aware of its dangerous side effects.
On the other hand, if a new study reveals that a certain plant or food is good for your metabolism and gut health, this will increase demand, especially if that study is credible.
Even though this would cause the price to increase, many consumers will still buy it due to its positive effects on health.