A Demand Shock is an unexpected event that results in a sudden and dramatic change in the economy’s aggregate demand or the demand for a good or service.
Sudden events such as natural disasters, wars, terrorism, or political decisions can trigger a demand shock, which reverberates through an economy. For example, a demand shock occurred when the COVID-19 pandemic led governments to implement stay-at-home orders and other containment measures. Consumer spending—or aggregate demand—plummeted. In April 2020, consumer spending dropped over 13%, and the consumer price index fell by 0.8%. These changes were both sudden and dramatic.
Before the pandemic, the US economy had been growing at an annual rate of about 2.0%. Consumer spending, the strongest component of the economy, had consistently increased since 2014, and prices were beginning to rise more quickly. However, the demand shock caused aggregate demand to decline sharply, reducing both the economy’s output and the overall price level.
The graph below illustrates this shift. The containment measures shifted aggregate demand from AD1 to AD2. As a result, output, measured by real gross domestic product (RGDP), decreased from RGDP1 to RGDP2, while the price level dropped from PL1 to PL2. Because demand shocks occur suddenly, the short-run aggregate supply curve (SRAS) remains unchanged. This reduction in output also leads to layoffs, exacerbating the economic downturn.
Fortunately, demand shocks typically do not last very long. Companies and consumers quickly adapt, and the underlying threat often subsides.
Demand shocks can also lead to higher prices. Natural disasters may trigger a demand shock in a specific region. For instance, the demand for bottled water spikes immediately after a hurricane. Similarly, the demand for building supplies and skilled labor increases as communities rebuild from the devastation. These sudden surges in demand often lead to higher prices for bottled water, construction materials, and labor.
This scenario would be represented on a graph by a rightward shift in the aggregate demand curve, leading to increased production and a higher price level. However, communities adapt over time, and production and prices typically return to normal levels.
Supply and Demand – Producers and Consumers Reach Agreement
Gross Domestic Product – Measuring an Economy’s Performance
Inflation
