Working Paper: NBER ID: w27152
Authors: David Baqaee; Emmanuel Farhi
Abstract: We study supply and demand shocks in a disaggregated model with multiple sectors, multiple factors, input-output linkages, downward nominal wage rigidities, credit-constraints, and a zero lower bound. We use the model to understand how the Covid-19 crisis, an omnibus supply and demand shock, affects output, unemployment, and inflation, and leads to the coexistence of tight and slack labor markets. We show that negative sectoral supply shocks are stagflationary, whereas negative demand shocks are deflationary, even though both can cause Keynesian unemployment. Furthermore, complementarities in production amplify Keynesian spillovers from supply shocks but mitigate them for demand shocks. This means that complementarities reduce the effectiveness of aggregate demand stimulus. In a stylized quantitative model of the US, we find supply and demand shocks each explain about half the reduction in real GDP from February to May, 2020. Although there was as much as 7% Keynesian unemployment, this was concentrated in certain markets. Hence, aggregate demand stimulus is one quarter as effective as in a typical recession where all labor markets are slack.
Keywords: COVID-19; supply shocks; demand shocks; Keynesian economics; inflation; unemployment
JEL Codes: E0; E12; E23; E24; E3; E52; E6; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative sectoral supply shocks (F41) | stagflation (E65) |
| negative demand shocks (E31) | deflation (E31) |
| negative demand shocks (E31) | Keynesian unemployment (J64) |
| negative sectoral supply shocks (F41) | Keynesian unemployment (J64) |
| complementarities in production (D10) | amplify Keynesian spillovers from supply shocks (E12) |
| complementarities in production (D10) | mitigate effects of demand shocks (E39) |
| supply shocks (E39) | reduction in real GDP (E20) |
| demand shocks (E39) | reduction in real GDP (E20) |
| aggregate demand stimulus (E00) | effectiveness in crisis (H12) |