supply side effects shock

Question 1

KAA

Answer 1

• Supply-side shocks often tip the economy into recession. For example, increases in costs such as energy reduce the profit margins of firms and reduce the incentive to supply. A fall in short run aggregate supply is then accompanied by lower output.
• Supply-side shocks may be inflationary. Firms may pass some of the increase in costs onto consumers in the form of higher prices, generating cost push inflation.
• The combination of recession and inflation means that the economy may experience “stagflation”
• Supply-side shocks may be associated with higher unemployment – as output shrinks, so too does the derived demand for labour.
• Supply-side shocks may damage competitiveness and lead to a worsening trade balance, especially if the shocks are specific to the UK.
• Supply-side shocks may lead to an increase in the budget deficit, because ceteris paribus, lower GDP will lead to lower tax revenue, and also higher government spending through benefit payments.

Question 2

evaluation

Answer 2

• Supply-side shocks may force firms to become more efficient in a bid to keep costs down.
• Supply-side shocks may not cause as high unemployment as they used to as the labour market is more flexible, so workers may work fewer hours but stay in jobs.
• Not all of the increase in costs as a result of a supply-side shock is passed onto consumers as higher prices. Inflation may be limited by firms absorbing some of the increase in costs as lower profit margins.
• The extent to which supply-side shocks damage competitiveness and the trade balance depends significantly on whether they are UK specific – for example, Brexit may have more of an influence on the UK’s trade position than the recent rise in energy prices, especially as the UK specialises in services and these are not energy intensive.
• The government may be able to cushion the impact of supply-side shocks (for example, through the furlough scheme which limited unemployment during Covid) although this involves discretionary changes to fiscal policy that are likely to worsen the budget deficit.
• The damage to the UK economy may have been intensified by the experience of a number of supply-side shocks in quick succession – In Spring 2023, the economy had still not recovered all of the output lost during Covid and GDP was still lower than pre-pandemic.
• Economic data in 2022-23 has helped to show how serious the effects of supply-side shocks can be – for example, inflation reached 11%, more than five times the target rate, in late 2022.
• However, not all of the UK’s current economic woes can be blamed on supply-side shocks. For instance, the UK has more enduring supply-side problems such as low productivity compared with other similar nations, and now a rise in economic inactivity too. This may help to explain why inflation in the UK in 2022-23 has been higher than in similar nations and why (in Spring 2023) the UK is the only G7 country where GDP is still lower than pre-pandemic.