Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?
Veronica Guerrieri Chicago Booth
Guido Lorenzoni Northwestern
Ludwig Straub Harvard
Iván Werning MIT
April 2, 2020
They present a theory of Keynesian supply shocks: supply shocks that trigger changes in aggregate demand larger than the shocks themselves. They 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. They 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.