Demand shocks are surprise events that lead to an increased or decreased demand for goods or services. They can lead to surging or falling prices as supply tends to be inelastic in the short-term. Over time, the shock fades and supply responds to find a new, sustainable equilibrium.
Positive Demand Shocks
Positive demand shocks have the effect of increasing aggregate demand in the economy, leading to increased consumption.
Examples of positive demand shocks include:
Companies anticipating increased revenues may respond by hiring more workers or expanding operations. This increase in hiring and economic activity feeds back to lead to even more consumption. One drawback of a positive demand shock is that it can lead to higher prices if the economy is near full capacity, which heightens inflation risks.
Negative Demand Shocks
Negative economic shocks have the effect of creating fear. In this mindset, people are more inclined to save rather than consume.
Examples of negative demand shocks include:
- Terrorist attacks
- Natural disasters
- Stock market crashes
In times of negative demand shocks, people are less inclined to take risks to start a business or pursue an education, which are activities integral to economic growth. Although these decisions may be rational on an individual basis, on an aggregate basis, it can lead to crippling economic losses.
To balance such a negative demand shock, governments may be inclined to lower interest rates, cut taxes or increase spending to reverse a self-reinforcing negative spiral. This is essentially intended to introduce a positive demand shock to counteract a negative one.
(For more, read "What Factors Cause Shifts in Aggregate Demand?")