Examining types of macroeconomic shocks

Macroeconomic shocks refer to any disturbance in the economy to internal or external factors. These shocks are mostly unpredictable and came without any signal and affect almost all the macroeconomic aggregates of the economy. Theses shocks may occur due to various reason such as oil price hikes, sudden fall in demand for any commodity, unpredicted fall in supply of any commodity, imposition of new tariff barriers in exporting countries, fall in domestic tariff barriers of the domestic economy, change in stock prices of large companies contributing a major part to the domestic countries national income and many more factors like this.

There are two types of macroeconomic shock these are supply shock and demand shock. First we consider the supply shock, which is defined as any sudden rise or fall in supply any commodity any given economic region in a given span of time. This rise or fall affects the macroeconomic aggregates in domestic as well as many related economies. When the supply of a good rises or falls suddenly then its prices fall or rises respectively and hence shifting the demand curve to right or left. The diagram below shows the affect of decrease in supply which results into rise in price of the commodity.

Similarly demand shock means that there is sudden increase or decrease in demand of any commodity due to which the price of a good decreases or increases. The demand shock may due to various reasons like tax cut which leads to individuals having more disposable income with them, this leads to more expenditure by them and hence increase in demand of any commodity. As drawn for the supply shock similar diagram can be drawn for demand shock causing a shift in the demand curve of that commodity.

Transmission mechanism refers to propagation of shocks from one country to another country through international trade in goods and services. When both countries are large then the transmission cannot be identified properly as disturbances may occur due to domestic economic problems.

Several theories of macroeconomic have proved that cross country business cycle correlation exists; it means the macroeconomic aggregates across countries are closely correlated. Many empirical studies are there to confirm this. The main reason of this is transmission mechanism and exogenous shocks.

Nature and Origin

The case study discussed here is from Canada which has effects on entire United States as well as Japan and Korea. It originated in Canada in 2003 spread all over. It was a demand shock. The food industry was the most hampered industry, also export and import sector was affected badly and faced a major loses. The share prices of some of the major food giants dipped drastically leading to a huge loses.

Immediately after the SARS threat which was a major shock to the Canadian Economy, it faced its first mad cow disease of the decade sending effect to whole of the North America. The incidence dates back to June, 2003; when a cow in Alberta, Canada’s top cattle producing province and also largest beef exporter to the United States, was found to be suffering of mad cow disease biologically known as brain wasting bovine spongiform encephalopathy. Actually the test was conducted on 31 cows in that province, picked in a very fair way without any bias. It was off course a domestic shock which affected the Canadian economy as well whole of North America.

Details

The mad cow disease news actually came out and spread out across the continent on 21th June, 2003. After that it took a late turn macroeconomic aggregates upsides down. Canada export sector was affected the most because beef was a major export. The domestic macroeconomic shock showed its color and resulted into bans on Canadian beef and also sale of cattle across the continent. Food industry was also drastically affected because beef is a major ingredient for many of the food items. This even affected the macroeconomic giant McDonald’s Corporation, the hamburger giant.

The government came into action swiftly as it was a serious issue. In severity of the matter comes from the fact that beef is a major of the food across the continent. Also beef is a complementary and supplementary item to many of the dishes. If proper attention was not paid at correct time then it would cause a dip in hazardous effects like deaths of thousands.

According to government orders cow with disease were slaughtered, so that they remain out of the food chain and do not adversely affect the life cycle. Total numbers of cow slaughtered were 150.

Economic Effects of the Supply Shock

It was like bad news coming from all sources to Canada as not only Canada’s own beef, food, export, Import industries declined but Canada was isolated. U.S., Japan, Korea all banned the import of Canadian beef. Japan and Korea also banned the import of diary products from Canada.

Canada feed almost 60% of the beef requirement of the continent and collected a amount of C$3.8 billion in annual farm cash receipts. After the shock it was shocks propagating everywhere On Wall Street, shares of Tyson Foods Inc., the biggest U.S. beef processor, fell 5 percent on the news and McDonald’s sank nearly 7 percent, which made making stock lose in Dow Jones on Tuesday.

U.S. cattle futures crashed their allowable daily limit on the Chicago Mercantile Exchange. The Canadian dollar, which has been soaring in recent past, fell on the mad cow report before regaining lost ground. Experts believe mad cow disease may have been spread by cows in Britain who were fed the remains of sheep contaminated with scrapie. Other scientists say the disease arose from a mutation in a cow in the 1970s. More than 80 people in Britain and Europe have died from the human variation of mad cow. So this was very deadly and could have serious affects on human lives.

The Model

Suppose we consider Canada as the small open economy which has international linkages to the world. International linkages refer to volume of tradeoff Canada with rest of the world. It also depends on frequency of trade. Volume of trade refers to the amount of goods traded whereas frequency of trade refers to the number of times the trade is done between Canada and other countries. It means when volume of trade is large then the export and import sector booms and earns large amount of revenue for the country.

Also, due to the international linkages and correlation between different countries macroeconomic aggregates affecting each other, there are other effects like effects on many macroeconomic aggregates, effects on the value of the domestic currency in terms of the country’s currency, effect on share prices of large companies.

To develop the model for Canada realizing the macroeconomic supply shock due to the mad cow disease producing disturbance in the economy we consider other macroeconomic aggregates also. These aggregates are largely affected by the shock produced in the economic.

Some of the supposition before constructing the model is:-

The economy is without friction for both domestic and international capital markets.

The residents of the economy are large in number.

The residents are also identical in economic behavior.

There is large dependence of economy on other economies.

Now, consider some of the variable

D1 = initial demand for beef by Canada and other nations

S1 = initial supply of beef from Canada

P1 = initial price of the beef

D2 = demand for beef after the cow disease

S2 = supply of beef after the cow disease

P2 = price of beef after the disease

Suppose the initial demand for the beef is D1, which aggregates the total demand in Canada as well as the United States. Then the supply was S1 which total the supply to Canada and rest of the world and the price was P1. When the cows were found to be suffering from mad cow disease and the demand for beef crashed and hence fell to large extend. There was fall in demand for raw beef as well as demand for beef as a raw material for many items, the major being hamburgers. The demand then fell to D2 and to fall in quantity supplied to S2. Due to this price also fell to P2. Canada being one of the largest producers and exporters of beef was harmed badly by this macroeconomic shock. It leads to a major change in economic variables in Canada. This shock was domestic in nature as it originated from Canada.

Empirical evidence

There are empirical evidence to show that there was fall in GDP in both Canada and U.S in 2003 that is the year in which the shock occurred. The annexure 1 attached with this article describes this. It can be seen that there in fall in GDP both for United States as well as Canada in the year of the shock. In 2003 the GDP of both the countries declined and shows the harmful effects of the demand shock. The conclusion can be drawn that the demand shock that originated from the mad cow diseases in 2003 spread through the continent. The annexure 2 and 3 also shows the up and down in Canada and U.S. economy through a graph.