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The Severity of Supply Shocks

By: Lexi Prochniak and Julia Jane Duggan

Supply shocks occur when there is a shift in the short-run aggregate supply curve. This could be due to a change in commodity prices, productivity, or nominal wages. There are both positive and negative supply shocks. A positive supply shock increases aggregate output and decreases aggregate price level, while a negative supply shock decreases aggregate output and increases aggregate price level. Therefore, with a positive supply shock, the graph shifts rightward and with a negative supply shock, the graph shifts leftward. While supply shocks are less common than demand shocks, their consequences are far more severe.

The economy has a harder time dealing with supply shocks than demand shocks, which is why the time periods following supply shocks, especially negative supply shocks, are much harsher than demand shocks. For instance, since World War II, there have been twelve recessions in the United States. Eight of these recessions were the result of a demand shock, which causes the aggregate price level and aggregate output to move in the same direction. The remaining four recessions were caused by supply shocks, and resulted in the lowest unemployment rates since World War II. Additionally, in each supply shock case, there was political turmoil occurring somewhere in the Middle East. The Arab-Israeli War in 1973 and the Iranian Revolution of 1979 were two events that both were factors of the supply shocks, as world oil prices were disrupted and thus greatly increased. The Great Recession of 2008 was also a product of a supply shock, and caused extremely low high rates of unemployment.

This graph clearly shows the jump in oil prices during 2008. This negative supply shock caused production costs to increase, thus causing the price of oil to greatly increase as well.

Thus, despite the fact that supply shocks do not occur often, they are nonetheless ruthless in their outcomes.  

Sources: FRED series CUUR0000SEHE and series NROU

14 thoughts on “The Severity of Supply Shocks

  1. bernsteinl20

    What about a supply shock that makes it much more "lethal"? Does it have to do more with the circumstances that cause it or does it just happen to be that these supply shocks have been much worse? Could a demand shock be just as bad in the right circumstances?

    1. bbschaeffer1

      Interesting question, Lee. I think supply shocks are felt by the consumers at a faster rate than demand shocks. Individuals do not change their demand based solely on a negative supply shock and when that event occurs, the consumers suffer the consequences because of a lack of goods and services available for consumption.

  2. dodsonm20

    The connection between recessions caused by supply shocks and turmoil in the Middle East occurring around the same time highlights the point made that change in commodity prices cause supply shocks. Do you have any examples that show how productivity and nominal wages can result in supply shocks? If neither played a large role in the supply shocks that resulted in economic recessions, should there be much of a concern to control them? I do find it interesting, however, that our economy is so reliant on the rest of the world that turmoil in a small group of countries in another continent can have such a large impact on our aggregate supply curve.

    1. Katherine Ingram

      One possible negative supply shock we briefly discussed was an epidemic or pandemic that dramatically decreased the labor force and therefore reduced productivity. I came across a paper published by the European Commission, which writes papers and investigations and offers legistlative/ policy aid to the EU. The European Commission modeled the effects of a pandemic to aggregate supply and demand. They expected a fall of 1.1% of GDP from supply effects alone and found that about two-thirds of the effects would be from the supply side. Here's a link for more information:

    2. bullr20

      An example of a supply shock caused by nominal wages: If the federal government raised the minimum wage to $15.00 an hour, many corporations (Mc Donalds, Walmart, etc) would experience a hike in operations cost, and would therefore be unwilling/able to sell their product at the original price. The price of big macs would go up, and the supply would likely decrease. Living wages may just be worth a negative Big Mac supply shock, but thats a very different/more complex debate...

      1. the prof

        Perhaps. Labor costs are not the major cost component at Walmart, and are lower than I assumed in fast food. In addition, an increase in minimum wages lowers turnover, something that fast food restaurants seem to be unable to accomplish on their own. Empirical work suggests a hike in the minimum wage can in some cases actually increase employment. So it might not be a negative supply shock, and certainly would not be a big one for a modest increase in minimum wages.

      2. minsong20

        I think the first step of McDonalds to respond to a higher minimum wage would be layoffs. I think the last thing they would do is raise the price of the menu. Instead there would be a marketing gamble that would raise sales.

  3. mannm20

    Aside from turmoil in the middle east leading to rising oil prices, what causes other supply shocks? Are there political or economic measures we could put in place to lessen the impact of supply shocks?

  4. scottm20

    Going off of the remark relating the Middle East to our domestic supply shocks, I immediately thought of the 1970s stagflation period that Levinson discussed in his book. The OPEC’s oil embargo, in which the group asserted its control over the price of oil, caused a ripple effect through the United States’ markets. While the nominal supply of oil did not necessarily change, the effective supply declined and subsequently led to a supply shock. The volatility of our means of supply, and dependence on foreign policy, is something interesting to follow as global politics continue to evolve.

  5. the prof

    What I know of the Great Depression suggests that it began as a standard demand shock, and then was amplified by policy mistakes and then by the inability to control bank runs (which had a supply-side impact and not just one on the demand side). So no, it's not necessarily the case that a supply-side one is worse.

    One challenge of addressing such questions empirically is that no single country has had that many recessions. So you ought to do a cross-national study. But then are you comparing apples and oranges? For that matter, is the economy of the US in the 1970s the same as that today? – there've been many structural changes, the financial system is very different today, agriculture and manufacturing are less important, as are demographics with Baby Boomer retirements.

    A final challenge is that the more interactions you build into a macro model, the harder it is to define supply and demand. Certain equations may be labeled "supply" but if the key variables are endogenous, then their both and neither.

  6. riversc20

    It probably shouldn't have been as shocking to hear that there have been 12 recessions since World War II, yet I still found this number surprisingly large. The fact that while only 4 of these 12 recessions were due to supply shocks, yet they caused the lowest rates of unemployment since World War II, really drives home your point that although infrequent, supply shocks can be detrimental. I think the point that supply shocks hit consumers harder is an interesting one; less supply in the market is definitely felt by consumers. Shortages are a notorious aspect of many recessions. Interesting to think about how crucial the role of the history of an economy is in seeing the big picture of history in general (political, social, etc)

  7. Mariam Samuel

    Levinson also discussed supply shocks, but mostly focused on the difficulties of implementing an actually shift to the short run aggregate supply through supply- side policy. With this in mind, I can understand that it is harder to respond to because it is more difficult to target. Like Professor, sort of mentioned, I can imagine that demand shifts (although in Levinson we have see are FAR from predictable) are easier to understand and manipulate because we have had more experience with that side of economics, especially in such a new country, but also world-wide.

  8. montjoyr20

    I would be interested to see if there were some kind of relationships between supply shocks and investment in productive capacity. for example, did investment in renewables increase significantly more following the oil supply shock of the 2000s, or did the negative impact of the supply shock itself actually limit the economy's ability to invest in this kind of activity?

  9. skinnerf20

    Demand shocks seem to be easier to manage from a policy standpoint, however, as we saw with the Great Depression, incorrect policy changes can amplify the issues faced by the nation. If countries can come up with contingency plans based on past mistakes and present ideas of the economic cycle it would hopefully be much easier and less harmful to manage these shocks.

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