COVID Macroeconomic Implications – Can a supply shocks bring demand deficiency ?

Jean-Baptiste Say is famously misquoted for stating the Law “supply creates its own demand.” In this paper, we introduce a concept that might be accurately portrayed as “supply creates its own excess demand”. Namely, a negative supply shock can trigger a demand shortage that leads to a contraction in output and employment larger than the supply shock itself. We call supply shocks with these properties Keynesian supply shocks. Temporary negative supply shocks, such as those caused by a pandemic, reduce output and employment. As dire as they may be, supply shock recessions are partly an efficient response, since output and employment should certainly fall.

However, can a supply shock induce too sharp a fall in output and employment, going beyond the efficient response? Can it lead to a drop in output and employment for sectors that are not directly affected by shutdowns? Relatedly, could this process produce an anemic recovery or is a V-shaped
recession assured?

These are the questions we seek to address in this paper. They are also the questions behind recent debates over monetary and fiscal policy responses to the COVID-19 epidemic and the ensuing economic fallout. We also examine the logic behind these class of stabilization measures.

We present a theory of Keynesian supply shocks: supply shocks that trigger changes in aggregate demand larger than the shocks themselves. We argue that the economic shocks associated to the COVID-19 epidemic—shutdowns, layoffs, and firm exits—may have this feature. In one-sector economies supply shocks are never Keynesian. We show that this is a general result that extend to economies with incomplete markets and liquidity constrained consumers. In economies with multiple sectors Keynesian supply shocks are possible, under some conditions. A 50% shock that hits all sectors is not the same as a 100% shock that hits half the economy. Incomplete markets make the conditions for Keynesian supply shocks more likely to be met. Firm exit and job destruction can amplify the initial effect, aggravating the recession. We discuss the effects of various policies. Standard fiscal stimulus can be less effective than usual because the fact that some sectors are shut down mutes the Keynesian multiplier feedback. Monetary policy, as long as it is unimpeded by the zero lower bound, can have magnified effects, by preventing firm exits. Turning to optimal policy, closing down contact-intensive sectors and providing full insurance payments to affected workers can achieve the first-best allocation, despite the lower per-dollar potency of fiscal policy.

Chosen excerpts by Job Market Monitor. Read the whole story @ Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?