The Effect Of Shifting The Aggregate Demand Curve - Demand Shocks
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Economics is immediately associated with the concepts of demand and supply. However, there is also a special demand case.
Definition
Demand shocks are certain events, both policy and non-policy, that have the effect of shifting the aggregate demand curve. Then demand suddenly and dramatically changes. There are two types of demand shocks: positive (positive) and negative (negative). They are classified as economic shocks.
From time to time, shocks or disturbances occur in the economy affecting economic dependencies, throwing the economy out of balance and which may require a policy response. Unpredictable events occurring in the economy are commonplace. They are influenced by, for example, the often inconsistent behavior of business people and the degree of technical sophistication of the financial system. These disruptions may be temporary or permanent. It is difficult to tell them apart when they occur. Transient disturbances can be ignored as they will soon disappear anyway.
A shock to aggregate demand periodically shifts the economy away from potential GDP and sends it into boom or recession. By gradually adjusting the price level, the economy eventually returns to normal. The cause of shocks are unexpected changes concerning, for example: fiscal and monetary policy of the state (easing or tightening), expectations of market participants as to possible profits or income, increase in private or public spending and changes in consumer preferences. Monetary and fiscal policy are important determinants influencing the shape and location of the aggregate demand curve.
Negative demand shock
It occurs when there is a sharp drop in demand. As a consequence, the aggregate demand curve shifts to the left.
Consequences:
- Falling GDP below the potential level,
- Lowering the price level (deflation),
- Interest rate decrease,
- Short-term decrease in supply,
- Increase in investment expenditures.
The gradual adjustment process will continue until real GDP returns to its potential level. Investments will increase by exactly the amount by which they initially decreased. The interest rate will be low enough to stimulate investment. Over the long term, real GDP will return to normal, but during a period of gradual price adjustment, the economy will go through recession and rising unemployment.
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Positive demand shock
It occurs when there is a sharp increase in demand. Then the aggregate demand curve shifts to the right.
Consequences:
- Initial drop in interest rate,
- Increase in investments, exports and consumption,
- Short-term increase in supply,
- Growth in GDP and prices (inflation), followed by an increase in the interest rate.
Through this process of gradual price adjustment, the economy will eventually return to normal. However, before that, it will go through a period of inflation and a boom in economic activity.
Policy response to demand shocks
Monetary or fiscal policy is able to compensate for the shock that affects aggregate demand. A shift in aggregate demand outward or inward can be reversed by a policy in the opposite direction.
In general, stability in aggregate demand is desirable. However, most economists argue that active policies could increase instability rather than compensate for it. Monetarists are even opposed to implementing policies that counter shifts in aggregate demand.
Other anti-active policy economists believe that demand compensation policies will have no effect on Gross Domestic Product (GDP).
Source: Begg D., Fischer S., Dornbusch R., (2007) Makroekonomia
