Demand and supply shocks, Financial Management

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Demand and Supply Shocks

The influence of the above macroeconomic factors on the economic performance can be analyzed by classifying their impact on the economy as a supply or demand shock. An event which influences the demand for goods and services in the economy is a "demand shock". For example, an increase in government spending, increase in money supply, reduction in tax rates create positive demand shocks. Similarly, an event that affects the production capacity and the costs is a "supply shock". For example, changes in the prices of imports, occurrence of any natural calamity, changes in the educational level of the economy's workforce create supply shocks.

Characteristics of Demand Shock

Demand shock causes aggregate output in the economy to move in the direction of interest rates and inflation. For instance, when the government increases its expenditure, it will lead to budget deficit. This will result in increase in government borrowing and hence the demand for funds and the interest rates. This will be followed by an increase in the inflation rate if the demand for goods and services rises to a level at or beyond the total productive capacity of the economy.

Characteristics of Supply Shock

Supply shock causes the aggregate output in the economy to move in the opposite direction of interest rates and inflation. For instance, a big increase in the price of imported oil will lead to increase in the cost of production thereby causing an increase in the prices of petrol products. This will lead to inflationary pressure. This increase in inflation rates will lead to higher nominal interest rates in the short-term. Hence, aggregate output will fall. Raw materials become more expensive and have a detrimental effect on production capacity of the economy. So the ability of individuals to purchase goods at higher prices decreases and thereby the GDP tends to decrease.

When an investor wants to identify a particular industry for his investments, he should be able to distinguish between those which aid in development from those which hurt in any perceived macroeconomic scenario. If one perceives a tightening of money supply in the near future, then one will avoid investment in the automobile industry because the likelihood of increase in interest rates will affect the sales performance of the said industry. But one should be aware that the predictions are made only with publicly available information which may not always be reliable. Any investment advantage can be made only by way of better analysis and not by the use of better information. An analyst must recognize that the basis for an investment should be the forecast for the industry relative to the forecast implicitly built into the security prices.

 


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