Economic Shock

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, according to real business cycle theory (RBC), are thought to be the root cause of recessions and economic cycles.

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. Finally, shocks can be considered either real or nominal shocks, depending on whether they originate from changes in real economic activity or changes in the nominal values of financial variables.

Because markets and industries are interconnected in the economy, large shocks to either supply or demand in any sector of the economy can have a 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. 

Types of Economic 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, too, as can man-made events such as 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. Financial shocks are the primary form of nominal shocks, though their effects clearly can have a serious impact on real economic activity.

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. Sometimes even a potential change in policy or an increase in uncertainty about future policy can create an economic shock before or without an actual policy change.

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, 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.