Biz con decline affects aggregate demand, decreasing business investment and causing recessions

Economic growth is the result of the interaction between aggregate supply (total production) and aggregate demand (total demand). There are two general types of causes of economic recession: supply shocks and demand shocks. A supply shock occurs when something reduces the economy’s ability to produce output at a given price level. A demand shock occurs when something reduces businesses’ and households’ willingness to consume and invest at a given price level. Supply and demand shocks happen unpredictably and irregularly, which is why expansions are not a regular length and recessions are hard to consistently avoid. Supply shocks and demand shocks can be caused by a variety of events, some of the most common of which are discussed below.

Not all economic shocks are so clear cut, and some have both supply and demand components. For example, the COVID-19 pandemic resulted in significant supply and demand disruptions. On the supply side, the pandemic caused disruptions in the production process as labor and trade became constrained. On the demand side, fears and mandated restrictions resulted in sudden decreases in consumer and business spending. While the following sections categorize shocks as purely supply or demand, in actuality, shocks may affect the economy through several channels.

Supply Shocks

Supply shocks, depending on their severity and breadth, can result in recession. When an event disrupts an economy’s productive capacity, typically by making an input to the production process scarce or relatively expensive, output will typically decrease and prices increase.7 In other words, supply-shock-induced recessions tend to exhibit falling output and employment and increased inflation. Owing to the increase in prices, a supply shock can often dampen aggregate demand as well, further exacerbating the downturn.

While supply shocks can come from anywhere in supply chains, typically shocks to inputs of the production process that are integral to production across the economy are the most likely to result in recession. For example, oil shocks are one of the most common causes of supply-related recession, as oil products (and other sources of energy) are used in the production of nearly all goods and services within the United States in addition to being a direct-to-consumer commodity. Other major commodities and inputs in the production process, such as labor or technology, can significantly boost or restrain aggregate supply in the economy. Thus, supply shocks can and have had their origins within the United States, but events outside of the country also affect domestic aggregate supply.

Example: 1970s Oil Crises

The 1970s were marked by two oil shocks. The first, taking place over several months in 1973- 1974, occurred when the Organization of the Petroleum Exporting Countries instituted an oil embargo on the United States. The embargo significantly decreased U.S. oil imports and increased the price of oil nearly fourfold.8 The United States experienced another oil shock in 1978-1979 when the Iranian Revolution resulted in decreased global production of oil. The shock also resulted in an increase in demand for oil, perhaps due to fear of further disruption. Altogether, the price of oil roughly doubled.9 Both shocks were followed by recessions (November 1973 to March 1975 and January 1980 to July 1980), and inflation remained high into the 1980s. Although they played a large role in these recessions, the oil shocks were not the sole contributing factors to the recessions, and oil shocks have not been the primary cause of recessions since then owing to a variety of factors, including increased domestic production and the buildup of oil reserves.10 The U.S. economy is continually experiencing various supply shocks, but most are not significant enough to cause a recession.

Current Conditions

The U.S. economy has seen several significant supply shocks in the past few years. In some ways, the COVID-19 recession was a supply shock: The need for social distancing halted commerce significantly, creating challenges in supply chains and resulting in idle productive resources (e.g., workers and factories). The Russian invasion of Ukraine also created significant supply disruptions in several commodities markets in 2022. Although this did not result in recession in the United States, these frictions can be seen in large price increases in several commodities, most notably energy, which fed through to high inflation. 11 Many supply chain issues improved in the latter half of 2022, and most economists expect these issues to continue to improve absent further shocks.12

Demand Shocks

A demand shock is characterized by an event or series of events that result in consumers and businesses cutting back on spending. Recessions induced by demand shocks exhibit lower output, but unlike supply shocks, they tend not to result in price increases and at times can even result in overall price level decreases (deflation). 13 For this reason, countercyclical monetary and fiscal policy may work better (or have more desirable outcomes) in dealing with demand as opposed to supply shocks

Changes in consumer or business confidence can impact aggregate demand. If individuals believe the economy will perform poorly in the future, they are likely to increase how much they save to prepare for lean times ahead. The associated decrease in spending would lower aggregate demand. Similarly, if businesses perceive that the economy is about to enter a recession, they are less likely to make investments in new machinery or factories because consumers would not be able to afford their new products during the recession. These types of changes in behavior can occur spontaneously and be the proximate cause of recession. These types of behaviors can also result from a specific shock and further deepen the shock’s demand impact.