The Effects of Asset Prices and Exogenous Shocks on the Economy

I recall in math the function of several variables, where a variable is dependent on some other variables.  In the case of macroeconomics, Quantity demanded is a function of the price of the good demanded the price of related goods (substitutes) or complementary goods.

Economic shocks are unpredictable and have an impact on Supply or demand throughout the markets. We recall what happened to the emerging markets a month ago, with currencies being devalued, and thus have a impact on imports and exports.  A shock in the supply of commodities, like oil, can cause prices to skyrocket.

If there is a surplus or shortage say in coffee, consumers will switch to its substitute, tea. If we think of the Supply and Demand curve, then any changes in one good will shift the equilibrium and the demand curve of that good. Any shock will inevitably create a shift in the demand curve, will create a shortage and thus lead to an increase in prices.

If personal income increases let us say, then consumers will demand more of a good at each price, and the demand curve shifts to the right. An increased demand will create a shortage, and thus an increase in prices.

Two complementary goods are cars and gasoline. If the price of gasoline rises, consumers will drive less, and car sales will decrease.

In one paper by the Federal Reserve of Dallas on “Large Global Volatility Shocks, Equity markets and Globalization”, they define shocks, with respect to the US equity markets,  as “months when unanticipated volatility in the stock market was exceptionally high”.

In another very interesting paper I found, “Monetary shocks and Bond Market Reactions”, December 1, 2008,  on the effect of monetary policy on bond yields, it states that exogenous shocks have a stronger impact on bond yields than an endogenous policy action does. I assume that they are implying the FED’s policy instruments, like open market operations, or increasing the money supply.

In another paper by the IMF, on “Measuring Oil Price shocks using Market based Information”, January 2011, they studied the effects of oil price shocks in the US economy since 1984. The paper suggests that there is no compelling evidence that after a positive oil price shock, GDP declines, and prices increase. Their data was based on spot prices. Spot Price is the price at any given moment in the market.

Their findings suggest that the US market has become less volatile and more insulated from external shocks, due to a smaller degree of energy dependence. Data was collected from oil trade journals, such as Oil Daily, and Oil and Gas Journal. Their data run from January 3, 1984 to October 31, 2007.

The responses of market information on exogenous Oil price shocks, were on GDP, the Federal Funds Rate (the rate at which the FED charges banks on overnight borrowing), the Consumer Price Index, and the real price of oil. So it is obvious, and the study found, that as a result of a positive oil price shock, real GDP declines, and the prices increase.

Another important and interesting factor the paper is pointing out is the effects of OPEC and Non OPEC oil price shocks. Although they are endogenous (internal), as the paper points out, this has to do with decisions of oil production output, and its impact on the global oil market. The implications are that real GDP declines and CPI rises.

In the last part of this very interesting paper, they examine the impact of military actions in the Middle East. The effects of oil price shocks tend to drive up prices of oil, and thus have an impact on production and output.