Development and Growth Constraints - External… | tutor2u Economics
Study notes

Development and Growth Constraints - External Shocks

  • Levels: A Level
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Shocks are unexpected changes in the economy that can affect variables such as the rate of inflation and the growth rate of GDP. In an inter-connected global economy, events in one part of the world can quickly affect many other countries. For example, the global financial crisis (GFC) brought about recession in many countries and financial distress in many regions. It also led to a fall in FDI flows into poorer countries and increased pressure on governments in rich nations to cut overseas aid budgets.

One distinction to make is between demand and supply-side shocks. Analysis of both encourages you to use the AD-AS analysis (including the diagrams!) you will have developed as part of Theme 2 in Year 12 economics.

Demand-side Shocks

  • Economic downturn / recession in a major trading partner
  • Unexpected tax increases or cuts to government spending programmes
  • Financial crisis causing bank lending /credit to fall and which spreads to more than one country/region
  • Unexpected changes in monetary policy interest rates
  • Significant job losses announced in a major industry

Supply-side Shocks

  • Steep rise/fall in oil and gas prices or other commodities traded in the world economy
  • Political turmoil / strikes
  • Natural disasters causing a sharp fall in production and damage to infrastructure
  • Unexpected breakthroughs in production technologies which can lead to unexpected gains in productivity
  • Significant changes in levels of labour migration into/out of a country

Exam hint:

A change in oil prices will have a complicated effect on the economies of different countries. Try to understand a little about the economic context facing each country. For example, is a country a net importer or an exporter of oil and gas? What scope do policy-makers to change variables such as interest rates and taxation in response to an external shock?

Volatile Incomes and Employment

  • Poor countries specialize in fewer and more volatile sectors
  • They tend to be smaller economies who cannot influence world prices
  • Poor countries tend to experience more frequent external shocks
  • These external shocks tend to be severe and affect millions of people
  • Fewer countries have extensive social security safety nets

Shocks can be positive (i.e. helpful in driving economic growth) and negative (e.g. a deep financial crisis which reduces confidence, spending and investment)

When analysing the impact(s) of an external shock, always remember to go back to the main macroeconomic objectives. Consider the likely impact on:

  • Real GDP growth
  • Inflation (demand-pull and cost-push)
  • Unemployment
  • Competitiveness
  • The Trade Balance
  • Government finances
  • Possible impact on inequality

Policies to absorb the effects of an economic shock

Not every country has the ability to respond quickly and effectively to external shocks. Much depends on how severely they are affected by economic events.

  1. Floating exchange rates (i.e. is there scope for a depreciation?)
  2. Freedom to set / adjust monetary policy when conditions change - does the central bank have autonomy to change interest rates or bring in unconventional policies such as QE?
  3. Geographically and occupationally mobile / flexible labour force - a more flexible labour force helps an economy adjust to shocks that change the pattern of exports
  4. Strong non price competitiveness of domestic businesses - this helps make demand and output more resilient to fluctuations in the global economy
  5. A diversified economy that is not over reliant on a few sectors
  6. Strong fiscal position (stabilisation funds) - e.g. strong finances give a government the scope to run a fiscal stimulus when aggregate demand falls

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