Economic Shock

Updated on April 4, 2024
Article byGayatri Ailani
Edited byGayatri Ailani
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Economic Shock?

An economic shock is any unanticipated event that creates a sudden and significant impact on the economy. The impact can be positive or negative. When it affects the economy negatively, the country confronts serious financial damage. A more recent example is the shock due to coronavirus outbreak, which affected various economies.

Economic Shock

According to economists, a shock generally ought to be “exogenous,” meaning that it originates from outside the economy rather than within. In addition, long-term trends are not identified as economic shocks since long-term trend gives the economy time to respond. For instance, the sudden collapse of an economy might be shocking, but the gradual decline of an economy over several decades would not be considered an economic shock.

Key Takeaways

  • The economic shock definition portrays it as any unexpected event causing a significant positive or negative effect on the economy. 
  • Different types include supply shock, demand shock, financial shock, and technology shock.
  • Sudden changes in aggregate demand and supply determinants, unexpected events in the financial sector, and technological developments can cause shocks in different forms.
  • Examples include the Russian financial crisis (2014–2016) and stock market crashes like the Wall Street Crash of 1929. 

Economic Shock Explained

The economic shock causes a quick, considerable change in an economy’s output, usually spurred by adjustments to external forces. Shocks induce an abrupt rightward or leftward shift in the aggregate supply or demand curve. Such occurrences have an impact on economic growth in addition to total output. It can affect the economy by causing inflation and spurring unemployment rates. 

Certain changes in the factors affecting supply and demand typically result in shocks. It can happen quickly and dramatically, in contrast to regular changes, and cause a significant and long-lasting economic impact. They affect economic cycles and can result in economic recession

Government can use various methods and strategies to recover from shock effects. For example, entities can abstain from using layoffs as a cost-cutting tool, maintaining a close watch on expenditure, creating a crisis plan, attempting to benefit from new or unconventional opportunities, and engaging in business operations with a long-term perspective.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Types

Economic shock categorization can be based on different factors. For example, based on the output, it can be a positive and negative economic shock. The shock can be the supply or demand side. They can also be categorized according to their origin, and the sector got impacted. Let’s look into some of the significant economic shock types:

1. Supply Shock

A supply shock generates an abrupt and unexpected change in aggregate output. These economic shocks arise when producing goods and services in one or more economic sectors suddenly becomes much more expensive or challenging. Events like natural disasters, input shortages, and price hikes can result in supply shocks. For instance, a natural disaster could result in a sharp decline in output due to an input shortage. The production costs drastically increase in response to a rise in oil prices, and aggregate output sharply decreases. 

Based on the outcomes, supply shocks are split into two categories: positive supply shock and negative supply shock. Negative supply shocks portray scenarios including rising wages and more expensive raw materials that drive manufacturing costs, altogether pushing enterprises to reduce output and increase the selling price. In contrast, positive supply shock features an increase in output and a subsequent decrease in price. 

2. Demand Shock

Demand shock happens when consumers drastically and abruptly alter their buying behavior and spending decisions. For example, consumers may cut back on buying if any economic event results in large-scale layoffs or affects their income. It could start a negative feedback loop where firms lose money due to decreased sales, resulting in further layoffs and decreased consumption patterns. 

The demand shocks are also categorized into two types: negative and positive demand shocks. The negative demand shock indicates a decrease in demand due to the global recession, increase in taxation, or trade war. In contrast, positive demand shocks indicate a sudden demand increase due to strong consumer confidence, tax benefits, etc.

3. Financial Shock

Financial shocks are usually unfavorable turbulences from the financial sector that can worsen a country’s economic activities. Financial shocks include an unexpected stock market crash, a liquidity crisis in the financial market, and a currency crisis

4. Technology Shock

Technology shocks are rapid technological breakthroughs that can substantially impact various sectors. Sometimes it can cause extensive upheaval affecting various industries, including transportation, education, banking, media, retail, and professional services. 

Examples

Let us look at economic shock examples to understand the concept better: 

Example #1

The financial crisis in Russia from 2014 to 2016 was caused by the rapid depreciation of the Russian rouble that began in the second half of 2014. Due to a decline in investor confidence in the Russian economy, investors started selling their assets, which reduced the rouble’s value and stoked worries about a potential financial disaster.

The loss of confidence in the Russian economy was mostly a result of several important factors, including the decline in oil prices in 2014, the decrease in crude oil export, and the impact of the imposition of numerous international economic sanctions.

Example #2

In May 2022, Malawi devalued its kwacha currency by 25% against the dollar, and the inflation in the country increased to 25.5% in August. Both points to the critical scenario present in the country. 

Malawi is currently facing lengthy lines at petrol stations running out of fuel due to a lack of foreign currency. Like this, several other scenarios also point to the country’s need for liquidity. If they get funds, they can utilize them to lessen the impact of shock by paying to import fuel and subsidized fertilizer. 

Frequently Asked Questions (FAQs)

What is a positive economic shock?

Positive shock creates a positive effect and is good for the economy to a great extent. For example, it can be a sudden increase in demand and consumption or a decrease in input prices and the associated increase in production and supply. 

What is external economic shock?

External shocks are events that occur outside of a country’s economic system. An external shock is an unanticipated occurrence that drastically alters the course of a whole economy, either upward or downward. One of the examples is the Global Financial Crisis (GFC) from 2007 to 2009, the effects of which are still being felt today.

How to recover from economic shocks?

Government and private entities can take certain measures to recover from shocks. For example, avoiding layoffs to reduce costs, checking on spending, preparing a crisis plan, trying to obtain profit from new or diverse opportunities, and engaging in business activities with a long-term view.

This article has been a guide to What is Economic Shock. Here, we explain its types and examples. You can also go through our recommended articles on corporate finance –