The economic policy response to the COVID-19 pandemic requires understanding whether the crisis is a problem of supply or demand. But Chicago Booth’s Veronica Guerrieri says that what starts as a supply shock can become a demand shock—and that the demand effects can grow larger than the supply shock that caused them.
Given the large and quick effect of the current pandemic on the economy, central bankers and governments have expressed the desire to do whatever it takes to help the economy to recover and to respond to this bad shock. So a natural question arises, which is: How can governments and central bankers help?
One important question is: Is this a moment in which we should stimulate demand or not? And if you want to frame this question—this is what we do in my work with Guido Lorenzoni, Ludwig Straub, and Iván Werning—in economics terms or in macroeconomic terms, this can be reframed as: Is the pandemic a shock to the economy that primarily affects the demand side of the economy? Or is it a shock that primarily affects the supply side?
The way in which we approach the problem is that we think that the pandemic can be represented primarily at first as a supply-side shock because it’s going to impact many sectors and the production of many goods and services that are going to be locked down. More highly contact-intensive sectors are going to also have a reduction in demand due to the private desires of individuals, even if a lockdown policy has not been put in place yet. This is clearly something that affects production and supply.
However, we show in our paper that this supply shock can propagate to the rest of the economy as a demand effect. And in particular, we show that the demand side can become even stronger than the original impact that the pandemic can have on the supply side.
Why is it important to think about demand and supply? Why is it important to think about whether an epidemic is primarily a supply or demand shock? First of all, for policy reasons, because if a shock is mainly affecting the demand side of the economy, then there is a demand shortage, and stimulating demand may be beneficial.
However, if the shock is on the supply side, stimulus may actually not be good. If the supply side is what is primarily negatively affected, this can generate inflationary pressure, and when inflation happens, stimulus is not good because it is exacerbating the problem.
We show that an epidemic that starts as a supply shock can become primarily a demand shock, which means that expansionary fiscal and monetary policy are actually beneficial. So it’s important to think about, when is it the case that a pandemic becomes primarily a demand shock?
We show there are two main ingredients in a macroeconomic model that make it clear that the pandemic is a demand shock. One is that we have to think of multiple sectors in the economy. When there is a shutdown in a sector—for example, restaurants are closed—what happens to demand in the other side? You may think that on the one hand, there are other sectors like take-home food that are going to be hit by a positive response in demand. On the other hand, there are other sectors like, for example, fancy clothing that are going to be hit negatively by that. People may decide not to buy as many new clothes to go out at night anymore.
If complementarity forces are going to be stronger in the economy, meaning if there are more sectors where the demand is going to be negatively affected by the shutdown of some sectors that are high-intensive contact in the economy, then the demand-side effect becomes stronger.
And it’s important to say that it’s not only about preferences, but the complementarity among sectors may arise also for other reasons that are more structural. It may be that there are inter-sectoral linkages, supply chains, that are important and that make the complementarity stronger.
And the direction in which it goes in our paper is the following: We show that the demand effect becomes stronger when the supply chain goes from the affected sector, stopping demand for intermediate inputs that are produced by the not-affected sector. Restaurants are closed; they used to demand lots of accounting services, and now suddenly the accounting service demand goes down because the restaurants are now closing.
These inter-sectoral linkages are going to be important and are going to make the demand effects of the pandemic even stronger, and so the desire for stimulus even stronger.
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