Working Paper: CEPR ID: DP15423
Authors: Luca Fornaro; Martin Wolf
Abstract: We study the effects of supply disruptions - for instance due to energy price shocks or the emergence of a pandemic - in an economy with Keynesian unemployment and endogenous productivity growth. By temporarily disrupting investment, negative supply shocks generate permanent output losses - or scarring effects. By inducing a negative wealth effect, scarring effects depress aggregate demand, which may even fall below the exogenous fall in supply. However, that scarring effects depress aggregate demand does not necessarily translate into low rates of inflation. On the contrary, scarring effects may reinforce and prolong the inflationary impact of supply disruptions. A contractionary monetary policy response may end up deepening scarring effects and increasing inflation in the medium run. A successful disinflation may require a policy mix of monetary tightening and fiscal interventions aiming at supporting business investment and the economy's productive capacity.
Keywords: Supply shocks; COVID-19; Hysteresis; Investment; Endogenous growth; Monetary policy; Fiscal policy; Zero lower bound; Keynesian growth
JEL Codes: E22; E31; E32; E52; E62; O42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative supply shocks (E31) | reduced investment (G31) |
| reduced investment (G31) | destroyed future productive capacity (E23) |
| negative supply shocks (E31) | permanent output losses (F69) |
| permanent output losses (F69) | scarring effects (E71) |
| scarring effects (E71) | depressed aggregate demand (E00) |
| tight monetary policy (E52) | exacerbated scarring effects (I12) |
| tight monetary policy (E52) | increased inflation (E31) |
| depressed aggregate demand (E00) | lower natural interest rate (E43) |
| lower natural interest rate (E43) | reduced consumer demand (D12) |
| reduced consumer demand (D12) | supply-demand doom loop (J23) |
| supply-demand doom loop (J23) | lower profits (D33) |
| lower profits (D33) | further cuts in investment (G31) |
| further cuts in investment (G31) | declining productivity (O49) |
| declining productivity (O49) | declining employment (J63) |
| investment decline (G31) | rising marginal costs (D40) |
| rising marginal costs (D40) | sustaining inflation (E31) |
| tight monetary policy (E52) | exacerbated inflation (E31) |