How can a supply shock affect AD?

A supply shock can affect Aggregate Demand (AD) indirectly by influencing prices and expectations of future prices.

A supply shock is an unexpected event that suddenly changes the supply of a product or commodity, resulting in a sudden change in its price. This can be either positive, leading to a sudden increase in supply, or negative, causing a sudden decrease. These shocks can have significant effects on the economy, particularly on Aggregate Demand (AD), which is the total demand for all goods and services in an economy.

When a negative supply shock occurs, such as a natural disaster or a sudden increase in the price of a key input, the supply of certain goods or services decreases. This leads to an increase in the prices of these goods or services. As prices rise, consumers' purchasing power decreases, leading to a decrease in consumption, one of the key components of AD. This decrease in consumption can lead to a decrease in AD.

On the other hand, a positive supply shock, such as a technological advancement or discovery of new resources, increases the supply of certain goods or services. This leads to a decrease in the prices of these goods or services. As prices fall, consumers' purchasing power increases, leading to an increase in consumption and potentially an increase in AD.

Furthermore, supply shocks can also affect AD through expectations of future prices. If consumers and businesses expect that a negative supply shock will lead to higher prices in the future, they may increase their current consumption and investment, leading to an increase in AD. Conversely, if they expect that a positive supply shock will lead to lower prices in the future, they may decrease their current consumption and investment, leading to a decrease in AD.

In conclusion, supply shocks can have significant effects on AD, primarily through their impact on prices and expectations of future prices. The direction of the effect depends on whether the supply shock is positive or negative.