Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?

37 Pages Posted: 9 Apr 2020

See all articles by Veronica Guerrieri

Veronica Guerrieri

University of Chicago - Booth School of Business

Guido Lorenzoni

Northwestern University; National Bureau of Economic Research (NBER)

Ludwig Straub

Harvard University - Department of Economics

Iván Werning

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: April 2, 2020

Abstract

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.

Suggested Citation

Guerrieri, Veronica and Lorenzoni, Guido and Straub, Ludwig and Werning, Ivan, Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages? (April 2, 2020). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2020-35, Available at SSRN: https://ssrn.com/abstract=3570096 or http://dx.doi.org/10.2139/ssrn.3570096

Veronica Guerrieri (Contact Author)

University of Chicago - Booth School of Business ( email )

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Guido Lorenzoni

Northwestern University ( email )

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National Bureau of Economic Research (NBER) ( email )

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Ludwig Straub

Harvard University - Department of Economics ( email )

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Ivan Werning

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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HOME PAGE: http://econ-www.mit.edu/faculty/iwerning

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