Working Paper: NBER ID: w26918
Authors: Veronica Guerrieri; Guido Lorenzoni; Ludwig Straub; Iván Werning
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.
Keywords: COVID-19; Supply Shock; Demand Shortage; Macroeconomics
JEL Codes: E21; E32; E60; I18
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Negative supply shocks (E31) | Demand shortages (J23) |
| Demand shortages (J23) | Contraction in output and employment (E23) |
| Negative supply shocks (E31) | Contraction in output and employment (E23) |
| Negative supply shocks (E31) | Decrease in workers' income (F66) |
| Decrease in workers' income (F66) | Decrease in spending (D12) |
| Decrease in spending (D12) | Contraction in demand (D12) |
| Contraction in demand (D12) | Job losses in affected sectors (F66) |
| Shutdown of some sectors (L52) | Mutes the Keynesian multiplier effect (E62) |