Demand Shock

It is a type of economic shock that can impact the aggregate demand for goods and services

Author: Josh Pupkin
Josh Pupkin
Josh Pupkin
Private Equity | Investment Banking

Josh has extensive experience private equity, business development, and investment banking. Josh started his career working as an investment banking analyst for Barclays before transitioning to a private equity role Neuberger Berman. Currently, Josh is an Associate in the Strategic Finance Group of Accordion Partners, a management consulting firm which advises on, executes, and implements value creation initiatives and 100 day plans for Private Equity-backed companies and their financial sponsors.

Josh graduated Magna Cum Laude from the University of Maryland, College Park with a Bachelor of Science in Finance and is currently an MBA candidate at Duke University Fuqua School of Business with a concentration in Corporate Strategy.

Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:March 12, 2024

What is a Demand Shock?

Demand Shock refers to an unexpected and sudden event that causes a temporary surge or decline in the overall demand for goods and services in an economy. To grasp this concept, it's crucial to understand the basics of supply and demand in economics.

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 are 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 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 Demand Shock is when there is a temporary increase in demand. On the other hand, a negative Demand Shock is a temporary decrease in the demand for a good or service.

It's essential to distinguish demand shock from supply shock. A supply shock is a sudden and temporary change in the supply of goods or services, impacting the production side of the economy.

It's important to note that the terms "positive" and "negative" in the context of demand shocks do not imply good or bad outcomes. Instead, they refer to an increase or decrease in demand. Excessive fluctuations in either direction can pose challenges for the economy.

Key Takeaways

  • Demand shock is an unexpected economic event causing a temporary increase (positive demand shock) or decrease (negative demand shock) in the aggregate demand for goods and services.

  • Positive demand shocks lead to a surge in demand due to factors like fiscal policies or positive reviews, while negative demand shocks result from events such as pandemics or tax increases, causing a decrease in demand.

  • Positive demand shocks shift the demand curve to the right, indicating increased demand at all price points. Negative demand shocks shift the curve to the left, signaling a decrease in demand across price levels.

  • Governments may intervene to counteract demand shocks. In response to a negative shock, measures like lowering interest rates may boost demand. Conversely, for positive shocks, interventions like raising interest rates or taxes may prevent excessive inflation.

Understanding Demand Shocks

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 demand shock usually stems from changes to the fiscal policy, including tax cuts or economic stimulus.  

Some events that can result in a positive demand shock include: 

The following graph shows the effects on the demand curve after a positive demand shock. 

Since a positive demand shock causes the curve to shift to the right, there are two consecutive effects given the supply curve does not shift: 

  1. 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. 
  2. 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 demand shock include: 

  • Pandemics 
  • Increases in taxes 
  • Increases in interest rates 
  • Increases in central bank rates 
  • Natural disasters 
  • Recalls 
  • Negative reviews 

The following graph shows the effects on the demand curve after a negative demand shock. 

Since a negative demand shock causes the curve to shift to the left, there are two consecutive effects given the supply curve does not shift. 

  1. 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.
  2. 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 demand shock, the government would take measures to increase aggregate demand. Thus, to counteract a negative demand shock, 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 demand shock during the financial crisis of 2008.  

The government may intervene in a positive demand shock as they do not want to give way to uncontrollable inflation. 

To contain a positive demand shock, 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 demand shock to counter the effects of a negative demand shock and vice versa. 

Demand Shock Examples

There are many examples of positive and negative demand shock 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 demand shock, but there are also some aspects of a positive demand shock 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 demand shock, 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 demand shock. 

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 demand shock. 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 demand shock. 

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. 

Researched and authored by Pooja Patel | LinkedIn

Reviewed and edited by Ankit Sinha | LinkedIn

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