A Negative supply shock is an economic concept that describes an unexpected event which suddenly and significantly reduces the overall supply of goods and services in an economy. It is also known as an adverse or unfavorable supply shock.
The concept gained prominence with the 1973 Oil Crisis, where the Organization of Petroleum Exporting Countries (OPEC) restricted the production and sale of petroleum, which is a key factor of production. This event caused the recession of 1974-75 and demonstrated the problem of simultaneous high inflation and low growth.
The mechanism works by shifting the short-run aggregate supply curve to the left on a macroeconomic graph. This shift results in a new equilibrium where the overall price level (inflation) increases, while the total quantity of goods and services produced (real GDP) decreases. Causes can include natural disasters, geopolitical tensions, or a sudden spike in the price of essential inputs like oil. For example, the Russia-Ukraine war fueled a recent supply shock to global grain markets.
The most critical concept connected to a negative supply shock is stagflation, which is the combination of stagnant economic growth and high inflation. This creates a dilemma for central banks, as policies to reduce inflation (like raising interest rates) can worsen the recession, while policies to stimulate growth can exacerbate inflation. The core concept remains the same, but recent events like the COVID-19 pandemic have highlighted that even temporary supply disruptions can lead to permanent output losses.