Responding to external demand and supply shocks

Overview

Negative external supply shock create a dilemma for policymakers, demand-side policy not correct a supply shock and floating exchange rate act as a shock absorber.

What you need to know

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Questions from this subtopic

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1. 1

   Distinguish a demand shock from a supply shock.

   Model answer

   A demand shock is an unexpected change in the willingness or ability of buyers to spend, so total spending in the economy changes while its capacity to produce is unaltered. A collapse in export orders, a loss of consumer confidence or a sudden tightening of credit are examples. A supply shock is an unexpected change in the economy's ability to produce or in the cost of producing, so the same output now costs more or cannot be made at all. A jump in energy or raw material prices, a disruption to a supply chain or the loss of part of the workforce are examples. The distinction matters because a negative demand shock reduces both output and inflationary pressure, so a single policy response addresses both, whereas a negative supply shock reduces output while raising prices, so no demand-side response can address both at once.

2. 2

   Why is the distinction between an external and a domestic shock important for policy?

   Model answer

   A domestic shock originates within the economy, so domestic policy acts on the cause as well as the symptoms; a government facing a domestic collapse in confidence can address it directly. An external shock originates abroad, so the cause is entirely beyond the reach of domestic policy, which can only cushion the consequences. A rise in world energy prices cannot be reversed by any domestic action, so the choice is limited to how the loss is distributed, how quickly the economy adjusts and whether the shock is allowed to become embedded in wages and prices. External shocks also arrive with a currency dimension, since the exchange rate moves in response and changes the size of the shock as it lands, and they often affect trading partners simultaneously, which means coordinated action is possible but also that the usual escape route of exporting more is closed.

3. 3

   Why is a negative external demand shock easier for policymakers to handle than a negative external supply shock?

   Model answer

   A negative demand shock pushes output and inflation in the same direction: spending falls, so output and employment fall and inflationary pressure eases. Both halves of the usual objective therefore call for the same response, namely to expand demand by cutting interest rates or loosening fiscal policy, and success on one front is success on the other. A negative supply shock pushes them in opposite directions: costs rise, so prices rise while output and employment fall. Expanding demand would support output but add to inflation; contracting demand would restrain inflation but deepen the fall in output. There is no setting of a demand-side instrument that improves both, so the policymaker must choose which objective to sacrifice and by how much.

4. 4

   How should macroeconomic policy respond to a negative external demand shock such as the collapse of a major export market?

   Model answer

   The appropriate response is to expand domestic demand to replace the lost external demand. Monetary policy can be loosened, cutting interest rates to encourage consumption and investment, with the added benefit that the currency will tend to depreciate, which improves competitiveness in remaining markets. Fiscal policy can support demand, and the automatic stabilisers should be allowed to operate fully rather than being offset. Discretionary measures can be targeted at the regions and industries most exposed, since the loss is concentrated rather than general, and public investment can be brought forward. Supply-side measures have a role too, in helping displaced workers retrain and in helping exporters diversify into other markets, though these act slowly. The main judgements are how permanent the loss of the market is, since a permanent loss requires structural adjustment rather than temporary support, and how much policy room exists.

5. 5

   How should policy respond to a positive external demand shock that threatens to overheat the economy?

   Model answer

   If demand from abroad is growing faster than the economy's capacity to supply, the excess will show itself in rising prices, rising imports and a widening current account deficit rather than in sustainably higher output. The response is to restrain domestic demand so that capacity can be directed to the export orders: raising interest rates reduces domestic consumption and investment and tends to appreciate the currency, which moderates the export stimulus itself, and fiscal tightening or simply allowing the automatic improvement in the budget balance to stand withdraws further demand. The more valuable response over time is on the supply side, expanding capacity through investment, training and measures to raise participation, since that allows the extra demand to be met with output rather than prices. The difficulty is judging whether the strength of demand is permanent, since tightening against a temporary surge risks leaving the economy weak when it fades.

6. 6

   Why does a negative external supply shock create a dilemma for policymakers?

   Model answer

   It raises the price level while reducing output and employment, so the two objectives that demand-side policy is normally used to reconcile move in opposite directions at once. Tightening policy to bring inflation back to target requires reducing demand still further, which adds to the fall in output and to unemployment on top of the real income loss the shock has already inflicted. Loosening policy to support output adds to demand at a time when supply cannot expand, so it raises inflation further and risks embedding it in expectations. Doing nothing means accepting a period of both high inflation and weak output. Since no demand-side setting improves both, the decision becomes a judgement about which objective matters more over what horizon, and in practice it turns on whether the price rise is likely to unwind and whether inflation expectations remain anchored.

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