Macro Economic Shocks and their Effects
A shock is an unexpected event that affects an economy. In this chapter we look at some of
the shocks that hit countries at different points in time and how macroeconomic policies can be
used to act as a ‘shock absorber’ or ‘stabiliser’ for an economy.
Open economies and macroeconomic shocks
The UK is an open economy meaning that a high (and rising)
percentage of our national income and output comes from trading
with the rest of the world; we are highly integrated within the
global economy. From one perspective this increases the sensitivity
of our economy to outside events for example a recession in key
export markets will inevitably have downside effects on demand,
output and employment in the UK. Changes in commodity prices
have direct and indirect effects on our producers.
However, trade and investment integration with other nations also
provides opportunities to smooth our own business cycle –
depending on what is happening to cycles, exchange rates and
policy changes elsewhere. Much rests on the flexibility of our
economy to be able to absorb external shocks and bounce back
when the opportunity arises. The need for a positive response has
been highlighted by the world economic recession of 2008-09.
Examples of shocks to the system!
There have been many exogenous shocks to the UK over recent years – some examples
include:
• A deepening integration of China, India other emerging market economies plus the
former Communist countries of Eastern Europe into the world economy.
• The ICT revolution in the mid-late 1990s and the dotcom boom-bust from 2000
onwards
• The emerging-market debt crisis and the collapse of Long Term Capital Management
in 1998
• Terrorist attacks on the World Trade Centre and subsequent conflicts in Afghanistan
and Iraq
• The quadrupling of world oil prices between 2004 and 2008 and huge rises in the
prices of many other commodities such as gas, copper, precious metals
• The sharp fall in world oil prices during 2009
• Rampant food price inflation in the global economy in 2007 and 2008
• The effects of the 25% appreciation in sterling between 1996 and 1998 – more
recently a 25% depreciation in the value of sterling against the Euro.
• The tripling in house prices between 1997 and 2007 followed by the descent of the
UK housing market into a steep recessionary period from 2008 onwards
• Substantial, and highly uncertain, inward labour migration flows into and out of the
UK
• The contagion from the unravelling of the sub-prime mortgage crisis in the United
States and the falling out the global credit crunch.
Exogenous shocks can be split into two main groups
Demand side shocks – affecting the components of demand in one or more countries.
Supply-side shocks – affecting costs and prices in different countries.
Demand Side Shocks
United States - GDP and Interest Rates
Percentage rate of growth year on year at constant prices
5 5
4 4
3 Economic Growth 3
2 2
Percent
1 1
0 0
-1 -1
-2 -2
-3 -3
7 7
US Base Rates
6 6
5 5
Percent
4 4
3 3
2 2
1 1
0 0
98 99 00 01 02 03 04 05 06 07 08 09
Source: OECD
The United States economy is suffering from its first recession since the early 1990s. The
downturn is largely the consequence of a negative demand shock for their economy linked to
the collapse of the sub-prime mortgage market and the failure of many leading investment
banks including Bear Stearns and Lehman Bros. The USA avoided a full-blown recession in
2001 after the 9-11 terrorist attacks and then enjoyed a phase of strong consumer-led
growth, but the descent into recession has been dramatic from the early months of 2008
onwards.
Examples of demand-side shocks might include
• A capital investment boom e.g. a construction boom or rapid growth of spending on
ICT
• A pre-election government spending spree or an unexpected reduction in taxation
(e.g. the government opting for a fiscal policy expansion before an election)
• A significant rise or fall in the exchange rate – affecting export demand and having
effects on output, employment, incomes and profits of businesses linked to export
industries
• A change in the rate of growth in one or more of the countries of our major trade
partners which affects the demand for our exports of goods and services
• An unexpected cut or an unexpected rise in interest rates (i.e. a “monetary policy
shock”)
Changes in aggregate demand brought about by a demand-side shock can create
disequilibrium in the economy, which takes growth, prices and incomes away from their
projected levels.
LRAS
Inflation
P2
P1
P3
SRAS1 AD1
AD1
AD3
Y3 Y1 Y2 Yfc Real National Income
Supply-Side Shocks
There are many possible supply-side shocks to the global economy. Some of them prove to
have beneficial effects, for example the emergence, adoption and take-up of a new
technology arising from invention and innovation that has the effect of reducing cost for
producers and prices for consumers. Often it takes several years for the full impact of supply-
side shocks to become apparent and for their full significance to be recognised.
LRAS
Inflation
P2
P1
SRAS2
SRAS1
Aggregate Demand
SRAS3 (AD)
Y2 Y1 Y3 Yfc Real National Income
Examples of inflationary supply-side shocks include shifts in global food prices and also the
world prices of oil, gas and other sources of energy. Shocks that bring about shifts in short run
aggregate supply are illustrated in the diagram above.
Supply shocks – the global oil market
The world prices of crude oil have been extremely
volatile in recent years. In the summer of 2008 a
barrel of crude cost more than $145 and there
were fears of stagflation hitting oil-importing
countries. By the start of 2009 the price had
slumped to the $30 level before rising once more to
settle between $55 and $65 a barrel. These notes
below focus initially on the impact of higher oil
prices.
The macro effects of rising oil prices depend on
several factors
1. The extent to which rising oil prices are
temporary or more permanent. In general, the impact of higher oil prices will be
larger the longer the price rise lasts. The possibility exists of “super-spikes” in oil prices
- including the jump up to $145 in July 2008 – these are short but sharp movements in
prices driven higher or lower by speculative buying and selling.
2. Whether a country is a net importer or exporter of oil – Britain was for many years a
net exporter of oil but this has now changed because of the decline in North Sea oil
production.
3. The extent of oil dependency of an economy i.e. the ratio of oil used per unit of
national output produced. Some countries rely on high-energy industries and are
exposed to volatile prices.
4. The extent to which oil users consumers can switch their demand away from oil towards
alternative energy substitutes.
5. The effects of exchange rate changes e.g. the pound might rise against the US dollar
which could absorb some of the effects of higher oil prices on the British economy since
oil (and most other globally traded commodities) are priced in dollars.
6. The extents to which the labour market is flexible (will workers accept a cut in real
incomes?) and the ways in which businesses react to higher oil costs – can they absorb
the higher costs and find efficiency savings elsewhere in their business?
World Crude Oil Price - US Dollars Per Barrel
US dollars
150 150
140 140
130 130
120 120
110 110
100 100
US dollars per barrel
90 90
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
03 04 05 06 07 08 09
Source: Reuters EcoWin
Main impact of higher oil prices on the UK economy
1. A fall in aggregate supply and higher inflation: A higher oil price causes an inward
shift in SRAS and is an example of an exogenous inflationary shock. The effects on
inflation can be increased if “wages follow prices” following a rise in inflation
expectations.
2. Supply-chain effects: Higher oil costs work their way through the supply chain. So
manufacturers and services such as airlines and utility companies pass on higher costs
to wholesalers who do the same to retailers. Higher prices for consumers reduce their
real purchasing power leaving less income available for buying other goods and
services.
3. Slower economic growth: For oil importing nations, higher oil prices act as a
dampening effect on the growth of real GDP. Consumption declines and businesses
using oil-related products as inputs make less profit (because of higher costs) this can
lead to a reduction in investment.
4. Jobs: Slower growth will hit jobs, not just in those industries that depend on oil but
across the whole economy. Another effect of rising oil prices could be to erode
business confidence.
5. A worsening of the terms of trade – the terms of trade measures the relative price of
imports compared to the prices that exporters receive for selling their output overseas.
An oil-price increase leads to a transfer of income from importing to exporting
countries through a shift in the terms of trade. For example the $140 per barrel price
of oil provided a huge increase in profits for oil exporting countries leading to a sharp
rise in their trade surpluses.
6. An increase in investment in oil substitutes – a rise in actual and expected levels of
oil prices will stimulate increased investment in substitutes for oil – we have seen this
with the growth of demand for bio-fuels, airlines investing in planes that have better
fuel efficiency, and a rise in demand for alternative energy sources such as solar
panels and wind farms. The danger is that volatile prices will worsen the economics of
alternative sustainable energy sources.
7. A worsening of the UK’s balance of payments – in contrast to previous oil price
shocks, the UK is now a net importer of oil.
Oil prices and interest rates
If oil prices cause inflation to accelerate, the response of the central banks – including the
Bank of England – might be to raise interest rates to bring inflationary pressures under control.
In reality, the situation is more complicated as our flow chart on the following page seeks to
show. The Bank of England does not have a specific target for oil prices – indeed the price of
crude is only one part of a complex jigsaw of factors that they must consider when considering
the likely path of inflation. CPI inflation did spike to over 5 per cent in the autumn of 2008 –
just a couple of months after the peak in oil prices. Since then oil and food prices have fallen
helping to bring CPI inflation back down towards the 2% target level.
UK Inflation and Crude Oil Prices
Annual percentage change in the Consumer Price Index and monthly average for Brent Crude
140 140
120 120
100 100
USD/Barrel
80 80
Crude Oil Price
60 60
40 40
20 20
0 0
5.5 5.5
5.0 5.0
4.5 4.5
4.0 Consumer Price Inflation 4.0
3.5 3.5
Percent
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
00 01 02 03 04 05 06 07 08 09
Source: UK Statistics Commission and IPE
Higher oil prices – the challenge facing monetary policy
Higher inflation Risk of a wage-price Policy response:
1st-round effects spiral due to rising
expectations Raise interest rates
What to do, and
Uncertainties: timing, magnitude & exchange rate effects when?
Rise in oil
prices
Consumers: Lower economic growth; Policy response:
2nd-round effects Real income falls Lower inflation pressure Cut interest rates
Companies:
Lower profitability
The evidence for the UK is that the volatility in crude oil prices is no longer as important in
influencing the rate of inflation as it was in the past. Our oil-energy ‘dependency ratio’ has
declined and the flexibility of our labour and product markets has increased, which has the
effect that pay is more flexible in response to changes in inflationary pressure. To add to this,
many businesses have experienced a decline in their ability to pass on increases in their input
costs when there are changes in raw material prices – this is partly due to the fierce
competition in many industries arising from globalisation.
That said the surge in cost-push inflation caused by accelerating food and oil prices did
contribute to the recession in the UK. Higher prices had a negative effect on people’s real
disposable incomes and also fuelled a worsening in consumer confidence. Higher prices for
essentials such as petrol and basic foods effectively acted as a tax on the consumer and hit
lower-income groups hardest.
Does the UK government benefit from high oil prices?
The rise in world oil prices tends to have a direct effect on two important macroeconomic balances –
namely the balance of trade in oil and secondly the government’s own finances. For countries such as
Saudi Arabia, Russia and Norway – all of whom are big net exporters of oil, the steep rise in the price
of exports of crude oil has had an unambiguously positive effect on both their balance of trade and
the health of government tax revenues. The huge sovereign wealth funds accumulated by the Russian
and Norwegian governments are testimony to their desire to use some of the funds from oil exports to
prepare for an economy ‘beyond petroleum’.
For the UK the situation is more complicated. The economy is still a substantial producer of oil but since
2005 we have become a net importer of oil and the share of imported gas in meeting our energy
requirements has also seen a sharp rise. And for the government higher oil prices are a double-edged
sword. On the one hand, taxes from the profits of North Sea oil companies are expected to bring in
£10bn this year – a fiscal dividend from higher global crude oil prices. One can add in the extra tax
revenues from dividends paid to UK-based shareholders of companies such as BP together with the
extra income tax, VAT and other revenues from stronger growth in the UK oil industry.
But on the downside, higher oil prices squeeze the profits of businesses that use oil as an essential input
into production – so they pay less in corporation tax – and it also contributes to rising inflation and
lower real household incomes, slowing down the economy and weakening the projected tax receipts
heading the Chancellor’s way.
Government spending too is affected by the higher price of crude oil. To take one example, it is
estimated that the armed services will spend an extra £500m this year in transportation costs to meet
their commitments around the world. That is a hefty increase in spending – little wonder that the
pressure is on to reduce training times in aircraft and tanks. The queues to use aircraft and tank
simulators will be getting longer in the months ahead.
Source: Tutor2u Economics Blog
Suggestions for further reading on oil prices and economic effects
Causation
Crude oil’s rollercoaster prices (BBC news, July 2009)
Non-OPEC oil could peak in two years (Times, July 2008)
Economic effects of high oil prices
High fuel prices – good or bad (BBC news, June 2008)
Oil is making food prices go up (BBC news, July 2008)
Background reports on the oil industry
FT Special Reports on Oil
Global oil industry in figures (BBC news, July 2008)
Guardian Special Reports on Oil and Petrol
Supply shocks – global food prices
Global Food Prices
Weekly index, 2000 = 100
300 300
275 275
250 250
225 225
Index
200 200
175 175
150 150
125 125
06 07 08 09
Source: Economist Commodity Price Index
The years 2007 and 20008 witnessed a huge rise in global food prices that gave rise to the
term agflation. This was another external shock to economies around the world. One of the
major reasons for rising food prices was the rising global price of wheat with wheat prices
rising 77% in 2007 alone. Many demand and supply factors were at work:
• Increased bio-fuel production: Concerns over oil prices, energy security and climate
change have prompted governments to take a more proactive stance towards
encouraging bio-fuels. This has led to increased demand for bio-fuel raw materials,
such as wheat, soy, maize and palm oil, and increased competition for cropland. This
led to a loss of resources targeted at the food chain and caused stocks of wheat to fall
to a 30 year low.
• Declining stocks were also affected by the worst drought in Australia in 100 years,
which halved the winter crop to 12 million tones in 2007.
• Desertification: Global warming and other environmental shifts are decreasing the
quantity of available farmland by over 7 millions hectares a year especially on the
African continent. If global warming continues water supplies could be disrupted
leading to falling food production. Deforestation, soil erosion and exhaustion are
examples of the Tragedy of the Commons.
• Speculation by investors: Wheat and other prices of commodities soared as they
found favour among investors who were struggling with poor returns in other markets.
• On the demand side, rising incomes in emerging market countries also contributed to
higher food prices. Per capita income has been rising in many emerging market
countries and so too has demand for foodstuffs that have a strongly positive income
elasticity of demand. An obvious example of this is the demand for meat products ñ a
land-intensive product. Meat is more land intensive, because you need land for the
livestock and crops to feed the livestock.
• Demographics: Demand has grown because of an expanding population - the global
population is expected to rise from 6 billion in 2000 to 9 billion by 2050.
• Currencies: The weakness of the US dollar increased the purchasing power of
speculators and other traders who can buy increased volumes of foodstuffs with
currencies other than the US dollar driving market demand to even higher levels.
• Export controls: Some food exporters acted to limit their sales overseas so as to
provide sufficient food for their own population. But whilst this helped to keep domestic
prices in check it reduced supply on world markets forcing prices higher for food
importers.
Index of real food crop prices, 2004=100.
2007 2008 2009
Real Prices
Maize 141 179 186
Wheat 157 219 211
Rice 132 201 207
Soybeans 121 156 150
Soybean oil 138 170 162
Sugar 135 169 180
Economic consequences
For the UK economy high food price inflation during 2007 and 2008 contributed to a surge in
inflation. In the UK it led in part to inflation overshooting the 2% inflation target. Inflation
peaked at an annual rate of 5% in the autumn of 2008. Inflation also accelerated within the
group of countries inside the Euro Area and in many poorer developing nations.
There are social and economic advantages from high food prices for example higher prices
are an opportunity to improve farmers’ incomes and to stimulate investments in farming.
For developing countries that are major exporters of food, the rise in world prices helped to
bring about an improvement in the terms of trade and a strong balance of payments. That
said higher food prices for domestic consumers created fresh problems of poverty. And most
developing nations are also dependent on importing food and other primary commodities
whose prices had surged.
Social consequences of food price inflation
1. Regressive effects: Lower income families often spend a higher proportion of their
budgets on food. Higher prices tend to hit them hardest causing a fall in real living
standards. They are also least likely to be able to bid for a compensating rise in
wages. This means that food price inflation can act like a tax on the poor and have a
regressive effect on the distribution of income. High prices price the poor out of the
food market.
2. Changes in diet: More expensive food bills might cause families to switch their
spending towards cheaper mass-produced processed foods that are high in salt and
sugar. Malnutrition can have damaging social effects including a rise in obesity, more
people suffering from Type-2 diabetes and a worsening of educational performance
in schools.
3. Deforestation and people forced off the land especially if countries give over more
land to growing crops for bio-fuels.
4. Social unrest: High food prices around the world led to riots in many countries
especially in those economies where agflation hit the real incomes of the urban poor
whose spending on food far outstripped their spending on other items. Many have
died because they have been unable to survive the rise in food prices, the World Bank
called this effect the ‘silent tsunami.’
Food price inflation and government intervention
Agflation brought a wide number of policy responses from countries around the world. They
included:
• An increase in cash transfer payments to vulnerable households - putting extra strain
on government spending and budget deficits Welfare payments have also included
bread or grain subsidies specifically targeted to the poor and also rationing card
systems to distribute subsidized wheat
• Rise in government spending on emergency food aid programmes and school feeding
schemes
• Lower tariffs on cereal imports - the World Bank reported in 2009 that twenty-four of
fifty-eight countries sampled had cut import duties and VAT in the wake of rising food
inflation
• Introduction of maximum prices on bread, rice and dairy products (staple products)
• Using higher interest rates to control demand-pull and cost-push inflationary pressures
• Some countries including Indonesia have considered reintroducing grain buffer stock
programmes to mitigate price volatility, despite the costs and problems of such
policies during the 1980s and 1990s
Estimate of the impact of high food prices on poverty
According to estimates from the World Bank, the increase in local food prices between
January 2005 and their average level of 2008 may have increased extreme poverty by
between 186 and 226 million people. It has revised its previous estimate and now says that
1.4 billion people live in poverty, based on a new poverty line of $1.25 per day.
Poverty numbers given food prices in 2008 Lower bound Upper bound estimate
estimate
(million)
East Asia & Pacific 112 133
Europe and Central Asia 8 9
Latin America & Caribbean 1 2
Middle East & North Africa 26 37
South Asia 14 20
Sub-Saharan Africa 24 26
Developing Countries (All) 186 226
Source: World Bank
Increasing food supply to control prices
In the medium term the world needs a fresh round of supply-side improvements to hold down
the pressure on food supplies and stop foodstuff prices spiking higher again.
The World Food Organisation and World Bank want governments to improve producer
incentives (including the removal of subsidies which benefit richer farmers more); invest in
public goods such as science and research projects, food supply infrastructure and human
capital; and strengthen institutions to support an attractive rural investment climate for men
and women, including more access to rural finance, improved property rights, and greater
opportunities for collective action by farmers; and policies to ensure a more sustainable use of
natural resources.
Suggestions for wider reading on global food prices and economic effects
World Bank – articles on the global food crisis
World Service Food Price Index (BBC)
World poverty more widespread (BBC news, August 2008)
The cost of food – facts and figures (BBC news, October 2008)
Water more important than oil (Guardian, February 2009)
World Bank demands poverty action (BBC news, April 2009)
Thai’s misguided rice policy (BBC news, July 2009)
Price curbs lead to cheaper food in Bolivia (BBC news, July 2009)
