The sudden closure of businesses around the world has contributed to a massive economic shock, and policy makers have scrambled to try to contain the damage. To many, it has seemed a clear supply shock—the term for what happens when an event interrupts the production of goods and services.
But the COVID-19 downturn involves more than that typical supply shock, write Chicago Booth’s Veronica Guerrieri, Northwestern’s Guido Lorenzoni, Harvard’s Ludwig Straub, and MIT’s Iván Werning. They argue that the supply shock has led to an even larger demand shock, as affected workers lose income and all consumers cut back on spending. Therefore, they write, policy responses need to address both types of shocks.
To combat the spread of COVID-19, many governments responded with lockdowns and shelter-in-place measures. Across the globe, businesses deemed nonessential closed, and their workers were instructed to stay home. This caused the huge supply shock, and usually the appropriate response would be to keep people afloat through social-insurance programs—and wait for productive capacity to revive when the pandemic passes.
Because of this, some policy makers and economists argued early on against government stimulus, which is the usual response to a shock caused by a lack of demand, as opposed to supply. After all, why should a government try to encourage people to spend money when the underlying issue is that they need to stay home?
But a supply shock can lead to a demand shock, according to Guerrieri, Lorenzoni, Straub, and Werning. “Demand may indeed overreact to the supply shock and lead to a demand-deficient recession,” write the researchers. It’s also possible that the deterioration of demand will have larger economic effects than the supply shock that caused it, and the researchers dub this a “Keynesian supply shock.”