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.”

Workers in shuttered industries lose spending power, so demand drops in all sectors. This can sap income from even unaffected workers—and dampen their willingness to consume.

This can happen because of the interrelated pieces of a complex economy. Closing businesses such as gyms, restaurants, and movie theaters can in some cases create demand for a different good or service—money that might have been spent on movie tickets or concerts goes to a streaming service, for example. But in other cases, it can hurt demand elsewhere. If yoga class is canceled until at least the end of summer, a studio member might see no immediate reason to spend money at sportswear stores such as Lululemon or Under Armour. If hotels are closed and business travel is canceled, there’s less need to buy luggage and attire, even if both are available for sale online.

What happens to total spending, then? Workers in shuttered industries lose spending power, so demand drops in all sectors. This can sap income from even unaffected workers—and dampen their willingness to consume.

The researchers’ model indicates that government purchases have limited effects in this environment. The government can’t spend in frozen sectors and isn’t able to move resources toward those affected businesses and workers.

But unemployment insurance and other direct payments to fired workers can mitigate the demand shock, providing households with the means to continue spending. This, by reducing the economic pain, will allow the government to continue lockdown measures when necessary, potentially shortening the length of the pandemic.

Initiatives including the Small Business Administration’s Paycheck Protection Program can help in this respect. Direct payments will keep waylaid workers solvent, and encouraging companies to furlough rather than fire workers can protect valuable labor-employer relationships that can eventually support the recovery.

Because of the complexities of the economy and the interplay between supply and demand, the recession ultimately needs to be mollified by a combination of stimulus and social support, as both have a role to play in mitigating the effects of a downturn.

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