Question

Explain fully the difference between a negative demand shock and a negative supply shock. Why is a negative supply shock worse for an economy compared with a negative demand shock? What policies are appropriate in dealing with a negative demand shock? What policies are appropriate in dealing with a negative supply shock?

Answer 1

Background - what we are calling shock is also referred as shift. And negative shock means shifting of curve to left and positive shock means shifting to right. Let's see the answer to the query above. Anything to the left is decrease and right is increase.

Ans.1 Difference between Negative Demand Shock (NDS) & Negative Supply Shock (NSS): Primarily, NSS leads to reduction in production this in turn leads to increase in prices of commodity or causing inflation. NDS leads to decrease in price of commodity but quantity demanded also falls that further means lesser production affecting employment.

Ans.2 NSS is worse because it brings inflation with lesser production & employment. The factors of production become expensive there by forcing manufacturers to be able produce lesser within the same amount of money or investment. This also affects the wealth valuation to decline & moreover the interest on capital will rise due to inflation and as a result manufacturers will invest invest lesser so investment also falls - quite a bad situation for economy.

Ans. 3 & 4 - To overcome NDS the policy needs to be tuned to increase the money supply in the economy and increase government spending ( In infra & other projects)

To overcome NSS subsidies from goverment in buying raw material and factors of production work wonders. Some time government give financial injection to the units to bring production it back on track and reduce stagflation.