A supply shock is an event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good. This sudden change affects the equilibrium price.
A negative supply shock (sudden supply decrease) will raise prices and shift the aggregate supply curve to the left. A negative supply shock can cause stagflation due to a combination of raising prices and falling output.
A positive supply shock (an increase in supply) will lower the price of said good and shift the aggregate supply curve to the right. A positive supply shock could be an advance in technology (a technology shock) which makes production more efficient, thus increasing output.
An example of a negative supply shock is the increase in oil prices during the 1973 energy crisis.
Technical analysis
The diagram below demonstrates a supply shock; The initial position is at point A, producing Y1 quantity, at P1 prices. Then there is a supply shock, this has an adverse affect on aggregate supply, the supply curve shifts left (from AS1 to AS2), while the demand curve stays in the same position. The intersection of the supply and demand curves has now moved and the equilibrium is now point B, quantity has been reduced to Y2, while prices have been increased to P2.
Given the inelasticity of both demand and supply, a large interest-rate fall is needed to close the saving/investment gap.
However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal economics began to fall out of favor.
Instead of rejecting macro-measurements and macro-models of the economy, the monetarist school embraced the techniques of treating the entire economy as having a supply and demand equilibrium.
Yet, in spite of this, the continued shocks that the United States’ economy received demonstrated that the business cycle downturn of 1931–33 was of a different kind than had previously been known.
Countries that were losing gold were obligated to permit their money supply to decrease and generate a decline in their domestic price level to restore equilibrium and maintain the fixed exchange rate of their currency.
The abandonment of the gold standard, the impact this had on the money supply, and the deliverance from the economic effects of deflation would have to be singled out as the most important contributor to the recovery.
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