The exact nature and cause of supply shocks is imperfectly understood. The most common explanation is that an unexpected event causes a dramatic change in future output. According to contemporary economic theory, a supply shock creates a material shift in the aggregate supply curve and forces prices to scramble towards a new equilibrium level.

The impact of a supply shock is unique to each specific event, although consumers are typically the most affected. Not all supply shocks are negative; shocks that lead to a boom in supply cause prices to drop and raise the overall standard of living. A positive supply shock may be created by a new manufacturing technique, such as when the assembly line was introduced to car manufacturing by Henry Ford. They can also result from a technological advancement or the discovery of a new resource input.

One positive supply shock that can have negative consequences for production is money inflation. A large increase in the supply of money creates immediate, real benefits for the individuals or institutions who receive the additional liquidity first; prices have not had time to adjust in the short run. Their benefit, however, comes at the expense of all other members of the economy, whose money loses purchasing power at the same time that fewer goods are available to them. As time moves forward, production becomes less efficient. Real wealth generators are left with fewer resources at their disposal than they otherwise would have had. Real demand drops, causing economic stagnation.

Negative supply shocks have many potential causes. Any increase in input cost expenses can cause the aggregate supply curve to shift to the left, which tends to raise prices and reduce output. A natural disaster, such as a hurricane or earthquake, can temporarily create negative supply shocks. Increases in taxes or labor wages can force output to slow as well, since profit margins decline and less efficient producers are forced out of business. War can obviously cause supply shocks. The supply of most consumer goods dropped dramatically during World War II as many resources were tied up in the war effort and many more factories, supply sites and transportation routes were destroyed.

Supply Shock and 1970s Stagflation

The most famous supply shock in modern American history occurred in the oil markets during the 1970s, when the country experienced a period of strong stagflation. The Organization of Arab Petroleum Exporting Countries (OAPEC) placed an oil embargo on several Western nations, including the United States. The nominal supply of oil did not actually change; production processes were unaffected, but the effective supply of oil in the U.S. dropped significantly and prices rose.

In response to the price increase, the federal government placed price controls on oil and gas products. This effort backfired, making it unprofitable for the remaining suppliers to produce oil. The Federal Reserve attempted to stimulate the economy through monetary easing, but real production could not increase while government constraints remained in place.

Here, several negative supply shocks occurred in a short period of time: reduced supply from an embargo, reduced incentive to produce from price controls and reduced demand for goods resulting from a positive shock in the supply of money.

Secondary Market for Houses: An Example

In 2011, researchers at the McDonough School of Business at Georgetown University gathered data on new and existing home sales in the United States between 1960 and 2010. They found that existing home sales volume was, on average, between six and 12 times larger than new home sales.

New home sales represent a primary market; a home builder is the original producer and issuer of the house. The first home buyer is the primary buyer. When the primary buyer decides to sell the home, it becomes a secondary market asset. Here, home buyers are negotiating with home buyers; no primary issuer is involved.

Imagine what would happen to the housing market if homes couldn’t enter a secondary market. Housing prices would be far less flexible and accurate than they are today, and almost no home buyers would enter the primary market, either. There isn’t much incentive to buy a permanently large asset that is locked into a specific location.

Economic Efficiency

Secondary markets are most commonly linked to capital assets such as stocks and bonds. It doesn’t take much time to think of plenty of other secondary markets, though. There is a secondary market for used cars. Consignment shops or clothing outlets such as Goodwill are secondary markets for clothing and accessories. Ticket scalpers offer secondary market trades, and eBay is a giant secondary market for all kinds of goods.

Secondary markets exist because the value of an asset changes in a market economy. These changes are driven by technology, individual tastes, depreciation and improvements, and countless other considerations.

Secondary market traders are, almost by definition, economically efficient. Every non-coercive sale of a good involves a seller who values the good less than the price and a buyer who values the good more than the price. Each party benefits from the exchange. Competition between buyers and sellers creates an environment where ask and bid prices meet at the buyers who value the goods most highly relative to demand.

Economic efficiency means that resources are driven to their most valued end. Secondary markets have historically reduced transaction costs, increased trading and promoted better information in markets.

Secondary Capital Markets

The most famous secondary markets are physical locations, even if many secondary trades are now completed electronically from remote locations. The New York, London and Hong Kong stock exchanges are among the most important and influential capital market hubs in the world.

Secondary markets promote safety and security in transactions, since exchanges have an incentive to attract investors by limiting nefarious behavior under their watch. When capital markets are allocated more efficiently and safely, the entire economy benefits.

Money laundering is the process of converting funds received from illegal activities into ostensibly clean money that does not raise suspicion from banks and financial institutions. Terrorists, organized criminals and drug smugglers rely extensively on money laundering to maintain cash flow for their illegal activities. Therefore, fighting money laundering is a highly effective way to reduce overall crime. Fighting money laundering uncovers financial records that often tie perpetrators to criminal activity. In cases of robbery, embezzlement or larceny, the funds uncovered during money-laundering investigations frequently are able to be returned to the victims of the crime. Additionally, taking away a criminal’s ability to launder money hampers his operation by shutting off his cash flow.

In today’s regulatory environment, extensive records are kept on just about every significant financial transaction. Therefore, when trying to uncover the identity of a criminal, few methods are more effective than locating records of financial transactions in which he was involved. Money laundering investigations center on parsing financial records for inconsistencies or suspicious activity; therefore, they often lead an investigator right to the front door of the criminal he’s chasing.

Uncovering money laundering is also an effective crime-fighting tool in that it frequently helps restore stolen money or property to its rightful owner. For example, when money that was laundered to cover up embezzlement is discovered, it can usually be traced back to the source of the embezzlement. While this does not necessarily nullify the original crime, it puts the money in question back in the proper hands and parts it from the perpetrator.

Lastly, money laundering is crucial for a criminal to run a successful operation. The money he makes is no good if he cannot use it to finance his operation and lifestyle. Therefore, attacking that aspect of his operation is one of the most effective ways to take down the whole thing.

Reported gross domestic product is adjusted for inflation. The growth of unadjusted GDP means an economy has experienced one of five scenarios:

1. Produced more at the same prices
2. Produced the same amount at higher prices
3. Produced more at higher prices
4. Produced much more at lower prices
5. Produced less at much-higher prices

Four of these scenarios either immediately or eventually cause higher prices or inflation.

Scenario 1 implies production is being increased to meet increased demand. Higher production leads to a lower unemployment rate, further fueling demand. Increased wages lead to higher demand as consumers spend more freely. This leads to higher GDP combined with inflation.

Scenario 2 implies there is no increase in demand from consumers, but that prices are higher. Through the early 2000s many producers were faced with increased costs due to the rapidly rising price of oil. Both GDP and inflation increase in this scenario. These increases are due to reduced supply of key commodities and consumer expectations, rather than higher demand.

Scenario 3 implies that there is both increased demand and shortage of supply. Businesses must hire more employees, further increasing demand by increasing wages. Increased demand in the face of decreased supply quickly forces prices up. In this scenario, GDP and inflation both increase at a rate that is unsustainable and is difficult for policymakers to influence or control.

Scenario 4 is unheard of in modern democratic economies for any sustained period and would be an example of a deflationary growth environment.

Scenario 5 is very similar to what the United States experienced in the 1970s and is often referred to as stagflation. GDP rises slowly, below the desired level, yet inflation persists and unemployment remains high due to low production.

Three of these five scenarios include inflation. Scenario 1 eventually leads to inflation, and scenario 4 is unsustainable. From this, it’s clear inflation and GDP growth go hand-in-hand. (For related reading, see: The Importance of Inflation and GDP.)

The level of productivity is the most fundamental and crucial determinant of a standard of living. Increased productivity allows people to get what they want faster, or to get more of what they want in the same amount of time. Supply rises with productivity, dropping real prices and increasing real wages; it lifts people out of poverty and allows them to focus on efforts beyond mere survival.

In economics, physical productivity is defined as the quantity of output produced by one unit of input within one unit of time. The standard calculation for economic productivity involves dividing output value per unit of input (e.g., 5 tons per hour). An increase in physical productivity causes a corresponding increase in the value of labor, which raises wages. This is why having an education or on-the-job training is sought after by employers; it increases the productivity of the workers and makes them more valuable assets for the firm.

To see how productivity raises wages, consider the following example. An employer offers you $15 to dig a 25-square foot hole in his backyard. Suppose that you have insufficient capital goods (your bare hands or a spoon), and it takes you three hours to dig the hole to his specifications. Your labor output is worth $5 per hour. If you had a shovel instead, it may have only taken you 30 minutes to dig the hole; your labor output just rose to $30 per hour. With a big enough crane, you may have been able to dig it in five minutes with a labor productivity of $180 per hour.

Capital goods – machines, technology, improved techniques – are crucial factors in determining productivity. To take a historical example, consider the economy of the United States in 1790 when nearly 90% of the working population was involved in agriculture. Fast forward to 2000 and, according to the U.S. census, less than 1.5% of the population was involved in agriculture. By percentage, agriculture consumed some 60 times as much labor in 1790, yet agricultural output is significantly larger today than in the 18th century. This makes food prices much less expensive today, and it frees up hundreds of millions of labor hours that can be employed towards other ends. This is how an economy grows.

Growth in productive capital requires periods of underconsumption. To take the time to build a better machine or lay infrastructure, producers must necessarily devote less energy towards making immediately consumable goods – the fisherman isn’t catching fish while he is mending his fishing net, for instance. These periods of underconsumption need to be funded, which is why businesses need investment for new capital projects. To supply this investment, consumers delay their own satisfaction and provide funding for businesses in exchange for (expected) greater levels of future consumption. This way, capital investment leads to greater productivity and future economic gains.

In economics, the assumption of ceteris paribus, a Latin phrase meaning “with other things the same” or “other things being equal or held constant,” is important in determining causation. It helps isolate multiple independent variables affecting a dependent variable. Causal relationships among economic variables are difficult to isolate in the real world, since most economic variables are usually affected by more than one cause, but models often depend on an assumption of independent variables.

In the real world, for instance, it would be nearly impossible to determine the causal relationship between the price of a good (dependent variable) and the number of units demanded of it (independent variable), while also taking into account other variables that affect price. For example, the price of beef may rise if more people are willing to purchase it, and producers may sell it for a lower price if fewer people want it. But prices of beef may also drop if, for instance, the price of land to raise cattle also drops, making it difficult to assume it was demand alone that caused the price change.

However, if these other variables, such as prices of related goods, production costs and labor costs are held constant under the ceteris paribus assumption, it is simpler to describe the relationship between only price and demand.

Ceteris paribus is also used in other fields such as psychology and biology. These fields have ceteris paribus laws that are assumed to be true only under normal conditions. (For related reading, see: What is the difference between ceteris paribus and mutatis mutandis?)

The law of demand is an economic principle that explains the negative correlation between the price of a good or service and its demand. If all other factors remain the same, when the price of a good or service increases, the quantity of demand decreases – and vice versa.

When all other things remain constant, there is an inverse relationship, or negative correlation, between price and the demand for goods and services. As the price of goods and services increases, the quantity demand falls.

For example, suppose all factors remain constant and the prices of barrels of oil are rising significantly. When the price of oil increases, the price of a plane ticket increases as well. This will cause a fall in the demand for plane tickets, because ticket prices may be too expensive for average consumers.

Suppose an individual wants to travel to a city 500 miles away, and the price of one plane ticket is $500 as opposed to $200 last year. She may be less likely to travel by air due to the increase in plane ticket prices. This causes her quantity demanded for an airplane ticket to decrease to zero. She is more likely to choose a more cost-effective way to travel such as taking a bus or a train.

Similarly, when the price of a product decreases, the quantity demanded increases. For example, suppose prices of barrels of oil are significantly decreasing instead. This cuts the costs for airline companies and causes a decrease in the prices of airplane tickets.

Suppose airline companies are only charging $100 as opposed to $500 in the previous example. The quantity demanded will generally increase. The individual may demand five tickets now, as opposed to zero before, because the price of one airplane ticket to travel 500 miles was cut by 80%.

Banks may securitize debt for reasons that include risk management, balance sheet issues, greater leverage of capital and to profiting from origination fees. Debt is securitized by the pooling of certain types of debt instruments and then creating a new financial instrument from the pooled debt. The types of debt instruments used may include residential mortgages, commercial mortgages, car loans or credit card obligations. The banks receive fees for selling the new debt security.

Banks may benefit from moving the default risk associated with the securitized debt off their balance sheets to allow for more leverage of their capital. By reducing their debt load and risk, banks can use their capital more efficiently. The securitized instruments created by pooling the debt are known as collateralized debt obligations (CDOs). The securitization process creates additional liquidity for debt instruments. While it is unusual for individual investors to own CDOs, insurance companies, banks, investment funds and hedge funds may trade in CDOs to obtain returns greater than simple Treasury yields.

Different levels of the debt, known as tranches, are sold to investors. The tranches are grouped together by different factors including the level of risk for the tranche or the maturity of the payments due for the tranche. Tranches are often given ratings that denote their perceived risk. The tranche rating determines the amount of principal and interest investors receive for buying that level of debt. Riskier tranches require higher interest rates, while tranches with higher ratings pay less interest. Defaults on subprime mortgages included in many CDOs are often cited as one of reasons for the 2008 financial crisis.

The countries with the largest budget deficits as of March 2015, in order, are Kuwait, Macau, the Republic of Congo, Norway, and Brunei. This is based on an examination of budget deficits as a percentage of gross domestic product (GDP), which puts all countries on a level playing field. Looking at it in terms of absolute budget deficit would lead to a much different outcome, but it would be skewed towards larger countries.

Even this list is somewhat skewed; it reflects the sudden weakness of oil in 2014, as it plunged more than 50% during the year. Many of these countries’ budgets were made with assumptions of much higher oil prices. If oil prices were higher in previous or future years, this list would be composed of countries that are importers of oil.

Budget deficits are the amount that government spending exceeds revenues, typically computed on an annual basis. The government must issue bonds to make up the difference or dip into its savings. Interest rates on a country’s bonds are determined by the market’s evaluation of the country’s ability to pay back its debt. Rising deficits lead to higher rates, especially if a country lacks sufficient savings.

Budget deficits, over time, eventually comprise a country’s national debt. Each year’s deficit or surplus determines the trajectory of the debt. Budget deficits are strongly correlated to the broader economy.

Increased economic activity leads to increases in tax revenues. Additionally, demand for government services declines as more people are employed. A strong economy boosts revenues and reduces expenditures. In contrast, a weak economy depresses tax revenues while increasing demand for government services.

Banks prefer to never have to write off bad debt since their loan portfolios are their primary assets and source of future revenue. However, toxic loans—loans that cannot be collected or are unreasonably difficult to collect—reflect very poorly on a bank’s financial statements and can divert resources from more productive activity. Banks use write-offs, which are sometimes called “charge-offs,” to remove loans from their balance sheets and reduce their overall tax liability.

Hypothetical Example of a Bank Writing Off Bad Debt

Banks never assume they will collect all of the loans they make. This is why generally accepted accounting principles (GAAP) require lending institutions to hold a reserve against expected future bad loans. This is otherwise known as the allowance for bad debts.

For example, a firm that makes $100,000 in loans might have an allowance for 5%, or $5,000, in bad debts. Once the loans are made, this $5,000 is immediately taken as an expense as the bank does not wait until an actual default occurs. The remaining $95,000 is recorded as net assets on the balance sheet.

If it turns out more borrowers default than expected, the bank writes off the receivables and takes the additional expense. So if our example bank actually has $8,000 worth of loans default, it writes off the entire amount and takes an additional $3,000 as an expense.

Consequences

When a nonperforming loan is written off, the lender receives a tax deduction from the loan value. Not only do banks get a deduction, but they are still allowed to pursue the debts and generate revenue from them. Another common option is for banks to sell off bad debts to third-party collection agencies.

(For related reading, see: What is the difference between a write-off and write-down?)