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How Negative Supply Shocks Can Lead to Demand Shortages

Understanding the nature of a negative economic shock is key to getting the policy prescription right. After ensuring that households have enough short-term resources, policymakers are confronted with the following conundrum: Should the aim of policy be to encourage people to spend more, that is to provide stimulus, or should policy focus purely on providing forms of social insurance?

The authors’ key insight is that the coronavirus shock is a supply shock of a special nature, as it affects different sectors unevenly. The central argument of their work is that the coronavirus shock will likely cause a reduction in aggregate demand larger than the original reduction in labor supply, something that the authors coin a “Keynesian supply shock.” Their work describes two forces that propagate the shock from those it directly affects, or those in affected (or contact-intensive) sectors, to those in less affected sectors: complementarities across sectors and incomplete markets. In the first case, when people are restricted from spending on certain goods, like restaurants and events, they do not spend the same amount on other complementary goods and services, and there is less overall spending

In the second case, the overall reduction in spending spreads to unaffected sectors because those who retain their jobs do not spend enough to prevent this occurrence (in economists’ parlance, the marginal propensity to consume of those in the unaffected sectors is less than those in affected sectors). Together, these two forces transform the original supply shock into a demand shock.

The authors’ findings pose challenges for policymakers, as a “typical” increase in government consumption may be less powerful in a pandemic shock. The reason is that government spending can only lift incomes in the unaffected sectors, not in the affected sectors, but it’s the workers in the affected sectors who have the highest propensity to consume, and they are exactly those who cannot benefit from an aggregate spending increase. On the other hand, fiscal stimulus can be desirable when combined with polices more targeted towards the workers in the affected sectors.