What is an Economic Shock?

An economic shock refers to any change to fundamental macroeconomic variables or relationships that has a substantial effect on macroeconomic outcomes and measures of economic performance, such as unemployment, consumption, and inflation. Shocks are often unpredictable and are usually the result of events thought to be beyond the scope of normal economic transactions. Economic shocks have widespread and lasting effects on the economy, and are the root cause of recessions and economic cycles in Real Business Cycle Theory.

Key Takeaways

  • Economic shocks are random, unpredictable events that have a widespread impact on the economy that are caused by things outside the scope of economic models. 
  • Economic shocks can be classified by the economic sector that they originate from or by whether they primarily influence either supply or demand.
  • Because markets are connected, the effects of shocks can move through the economy to many markets and have a major macroeconomic impact, for better or worse. 

Understanding Economic Shocks

Economic shocks can be classified as primarily impacting the economy through either the supply or demand side. They can also be classified by their origin within or impact upon a specific sector of the economy. Because markets and industries are interconnected in the economy, large shocks to either supply or demand in any sector of the economy can have far-reaching macroeconomic impact. Economic shocks can be positive (helpful) or negative (harmful) to the economy, though for the most part economists, and normal people, are more concerned about negative shocks. 

Supply Shocks

A supply shock is an event that makes production across the economy more difficult, more costly, or impossible for at least some industries. A rise in the cost of important commodities, such as oil, can cause fuel prices to skyrocket, making it expensive to use for business purposes. Natural disasters or weather events, such as hurricanes, floods, or major earthquakes, can induce supply shocks, as can man-made event like wars or major terrorism incidents. Economists sometimes refer to most supply side shocks as "technological shocks."

Demand Shocks

Demand shocks happen when there is a sudden and considerable shift in the patterns of private spending, either in the form of consumer spending from consumers or investment spending from businesses. An economic downturn in the economy of a major export market can create a negative shock to business investment, particularly in export industries. A crash in stock or home prices can cause a negative demand shock as households react to a loss of wealth by cutting back sharply on consumption spending. Supply shocks to consumer commodities with price inelastic demand, such as food and energy, can also lead to a demand shock by reducing consumers real incomes. Economists sometimes refer to demand side shocks as "non-technological shocks."

Financial Shocks

A financial shock is one that originates from the financial sector of the economy. Because modern economies are so deeply dependent on the flow of liquidity and credit to fund normal operations and payrolls, financial shocks can impact every industry in an economy. A stock market crash, a liquidity crisis in the banking system, unpredictable changes in monetary policy, or the rapid devaluation of a currency would be examples of financial shocks.

Policy Shocks

Policy shocks are changes in government policy that have a profound economic effect. The economic impact of a policy shock might even be the goal of a government action. It could be an expected side effect or an entirely unintended consequence as well. Fiscal policy is, in effect, a deliberate economic demand shock, positive or negative, intended to smooth out aggregate demand over time. The imposition of tariffs and other barriers to trade can create a positive shock for domestic industries but a negative shock to domestic consumers.

Technology Shocks

A technology shock results from technological developments that affect productivity. The introduction of computers and Internet technology and the resulting increase in productivity across many different occupations is an example of a positive technology shock. Economists often use the term technology in a much broader sense than it is understood by most people, so that many of the above examples of economic shocks, such as a rise in energy prices, would also fall under the category of technology shocks. However, people also often refer to shocks specifically originating from the technology sector as technology shocks.