Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?

Motivated by the effects of the COVID-19 pandemic, we present a theory of Keynesian supply shocks: shocks that reduce potential output in a sector of the economy, but that, by reducing demand in other sectors, ultimately push aggregate activity below potential. A Keynesian supply shock is more likely when the elasticity of substitution between sectors is relatively low, the intertemporal elasticity of substitution is relatively high, and markets are incomplete. Fiscal policy can display a smaller multiplier, but the insurance benefit of fiscal transfers can be enhanced. Firm exits and job destruction can amplify and propagate the shock.

Automated summary

Motivated by the COVID-19 pandemic, this study presents a theory of Keynesian supply shocks, which occur when a reduction in potential output in one sector leads to a decrease in aggregate activity below potential by reducing demand in other sectors. The likelihood of such shocks increases when there is low elasticity of substitution between sectors, high intertemporal elasticity of substitution, and incomplete markets. The study suggests that fiscal policy may have a smaller multiplier effect in such shocks, but the insurance benefit of fiscal transfers can be enhanced. Firm exits and job destruction can further amplify and propagate the shocks.