What would we expect firms to do in situations of sticky prices and negative demand shocks?

A sudden and temporary increase or decrease in the demand for a good or a bundle of goods

What is a Demand Shock?

A demand shock is a sudden and temporary increase or decrease in the demand for a good or a bundle of goods. Usually, the phrase “demand shock” is used in the context of aggregate demand, which describes the cumulative demand for an entire economy.

Summary

• Demand shocks are factors that cause a temporary increase or decrease from the standard level of aggregate demand.
• Demand shocks can last from a few days to several years.
• Both prices of transactions and quantity supplied and consumed will move in the same direction as the aggregate demand.

A Shift in Demand

A temporary change in demand can be caused by any factor that:

• Allows consumers to consume more, or
• Induces consumers to want to consume more

Many factors allow consumers to consume more (such as a universal tax cut that allows consumers to receive more to spend) and many factors that induce consumers to consume more (such as warmer weather increasing the demand for cold drinks during the summer months).

Graphically, a demand shock is shown as a shift of the entire demand curve. Equivalently, we can say that the shock causes the quantity demanded to increase or decrease at any given price.

Change in Price Cannot Cause a Demand Shock

A movement along the demand curve reflects a change in quantity demanded due to a change in price and is not a demand shock.

In the graph above, there is a change in quantity demanded due to a change in price. Thus, this graph does not reflect a demand shock.

We can see that as price changes, quantity demanded changes, but the demand curve does not shift.

Duration of Demand Shock Effects

The duration of the effects of demand shocks can vary greatly. Although the effects are described as “temporary,” there are no rigorous guidelines as to how “temporary” is defined.

Instead, “temporarily” is used to present the notion that the economy is in an irregular state and that aggregate demand is different from what economists consider standard.

Depending on the context of the demand shock, effects can range from a few days to several years.

Example of a Short-Term Temporary Decrease in Demand

A short, temporary decrease in demand lasting a few days can be a food product recall that renders consumers wary of buying the aforementioned products.

If the food safety authorities can recall all faulty products quickly, the public will start consuming that product at its regular level again within a few days.

Example of a Long-Term Temporary Decrease in Demand

A long, temporary decrease in demand can be caused by a factor, such as a disease pandemic. In such a case, most economic activity is suspended until an approved vaccine is available.

However, medical professionals may take years to find an effective vaccine, and consequently, the resumption of regular economic activity may be delayed for several years.

Positive and Negative Demand Shocks

A demand shock can either temporarily increase or decrease demand. Graphically, the entire demand curve would shift left or shift right, respectively.

Positive Demand Shocks

Positive demand shocks cause aggregate demand to increase. As shown below, the entire demand curve shifts right. We see that, at any price, the quantity demanded’s increased.

There can be many factors that can lead to a positive demand shock. Some of them include:

• Government tax cuts
• Government stimulus plans
• Central bank rate cuts
• The introduction of a new technology
• The discovery of a previously unknown benefit of a medicine

Negative Demand Shocks

Negative demand shocks cause aggregate demand to decrease. As shown below, the entire demand curve shifts left. We see that, at any price, the quantity demanded’s decreased.

There can be many factors that can lead to a negative demand shock. Some of them include:

• Government tax increases
• Central bank rate increases
• The cancellation of a government infrastructure project
• The discovery of a harmful compound in a specific cleaning sanitizer
• The discovery of a previously unknown side effect of a medicine

Effects of Demand Shocks on Prices and Quantity

When analyzing demand shocks, it is important to analyze two aspects of the economy.

1. The first aspect is how the price of transactions changes; that is, the comparison of the price at which buyers buy and sellers sell before and after the demand shock.
2. The second aspect is the quantity demanded and supplied; that is, the comparison between the amount of quantity supplied and consumed before and after the demand shock.

The conventional method of analysis is to keep the supply of goods constant to see the pure effect of the demand shock.

Such a technique works with either a specific good (e.g., pencils) or a basket of goods (i.e., household products). We will demonstrate the analysis below, assuming normal goods are being analyzed.

Positive Demand Shocks

When the supply is kept constant and demand increases, we expect the quantity supplied and consumed and the price of the transactions to increase.

Specifically, the rationales are as follows:

• The price of the transactions increases because, as consumers want to consume more (due to the demand shock), they are willing to pay more.
• The quantity supplied and consumed increases because as the prices increase, suppliers are willing to produce more.

Graphically, we can see that the price increases from P0 to P1, and quantity supplied and demanded increases from Q0 to Q1.

Negative Demand Shocks

Analogous to the previous section, when demand is shocked to decrease (while supply is kept constant), we expect both the quantity supplied and consumed, as well as the price of the transactions to decrease.

The rationales are as follows:

• The price of the transactions decreases because as consumers want to consume less (due to the shock), they are willing to pay less.
• The quantity supplied and consumed decreases because, as the prices decrease, suppliers are willing to produce less.

Graphically, we can see that the price decreases from P0 to P1, and quantity supplied and demanded decreases from Q0 to Q1.

More Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Aggregate Supply and Demand
• Consumer Surplus Formula
• Inelastic Demand
• Keynesian Economic Theory