In economics a shock is an unexpected change in the economy or a component of the economy. The hypothesis of rational expectations holds that individuals will incorporate all available and relevant information into their decision-making processes. From a behavioral standpoint, shocks are important in that they alter individuals’ behaviors by altering the information that goes into their decision-making processes. This alteration in behaviors in turn has economic consequences.
Because of people’s ability to anticipate changes in the economy, shocks are difficult to measure. In the past, changes in economic measures have been taken as proxies for shocks. For example, if inflation increased from 3 percent to 4 percent, economists would say that a 1 percent positive shock to inflation had occurred. This approach is not entirely satisfactory as the greater the ability of individuals to anticipate the change, the less the change represents a shock. For example, a rise in the price of gasoline from $2.50 to $2.75 would have represented a shock of $0.25 only if people expected that the price of gas would remain at $2.50. If people had expected the price of gas to rise from $2.50 to $2.75 and the price of gas actually did rise from $2.50 to $2.75, then the change in the price would have represented no shock at all. If, however, people had expected that the price of gas would rise from $2.50 to $2.75 but in fact the price only rose from $2.50 to $2.60, then the change in the price of gas would have been $0.10 and the shock would have been negative $0.15. That is, people would have anticipated an additional $0.15 price increase that never materialized. The difficulty in measuring shocks lies in the difficulty of knowing how much of a change in an economic measure was anticipated and how much was unanticipated.
While an unanticipated change in any economic measure can be described as a shock, economists give most attention to inflationary shocks (unanticipated changes in inflation), production shocks (unanticipated changes in the growth rate of real gross domestic product [RGDP]), and leading shocks (unanticipated changes in leading economic indicators). Positive inflation shocks represent unanticipated price growths and lead to reduced real wages and a slowdown in consumption. Positive production shocks represent unanticipated increases in real economic activity and can lead to an unanticipated reduction in inflation and growth in real wages. Leading economic indicators typically change direction prior to a turning point in business cycles. Unanticipated changes in leading economic indicators can indicate the approach of a turning point in the business cycle.
Methods for measuring economic shocks require multidimensional panel forecasts. A multidimensional panel forecast data set is a set of forecasts generated by multiple forecasters over multiple time periods and forecasting at multiple time horizons. For example, forecasters A, B, and C (multiple forecasters) will forecast inflation for the year in January, again in February, again in March, and so on (multiple horizons), and they will repeat this every year over a number of years (multiple time periods). Assuming that economic forecasters are rational, the forecasts can be taken to be reasonable measures of people’s expectations about the future, and even if the forecasters are biased, the biases can be filtered out such that estimates of economic shocks can be extracted from what is left. Measures of shocks and volatilities of shocks can be extracted from multidimensional panel forecasts via econometric methods.
The volatility of shocks is the variance of the shocks hitting the economy over time. For example, the economy may experience a sequence of large positive and negative shocks that mutually cancel each other out such that the net shock over the period is zero. However, the volatility of the shocks over the period will be nonzero as the shocks rose to positive levels then fell to negative levels. Consumer and investor uncertainty is a function of both shocks and the volatility of shocks. Uncertainty in turn impacts economic growth. The more uncertain consumers are about the future, the less likely they are to engage in transactions and so the slower is economic growth. Similarly the more uncertain investors are about the future, the less likely they are to invest and so the slower is economic growth. Studies indicate that the relationship between shocks and volatility is asymmetric. Negative shocks tend to be associated with greater volatility than positive shocks. This is typically interpreted as individuals regarding bad news of a given magnitude as being more influential on their decisions than is positive news of the same magnitude.
SEE ALSO Business Cycles, Empirical Literature; Business Cycles, Real; Expectations; Expectations, Implicit; Expectations, Rational; Involuntary Unemployment; Natural Rate of Unemployment; Phillips Curve; Risk; Say’s Law; Uncertainty; Voluntary Unemployment; Walras’ Law
Davies, Antony. 2006. A Framework for Decomposing Shocks and Measuring Volatilities Derived from Multi-Dimensional Panel Data of Survey Forecasts. International Journal of Forecasting 22: 373-393.
Engle, Robert F., and Victor K. Ng. 1991. Measuring and Testing the Impact of News on Volatility. National Bureau of Economic Research Working Paper No. W3681.
Parkin, Michael. 2005. Macroeconomics. Boston: Addison Wesley.