Although the economic effects of the virus will be complex, and we are sure to see some surprises, we can learn a lot from a simple model of the macroeconomy used in Econ 101 courses everywhere. This new slideshow presents a brief tutorial.
The model used in the tutorial is based on the concepts of aggregate demand and aggregate supply.
- Aggregate demand means the amount of real output – the inflation-adjusted quantity of goods and services – that consumers and firms want to purchase at any given time. Other things being equal, the quantity demanded is greater when the price level is lower.
- Aggregate supply means the quantity of real output that firms are willing to supply in response to the prevailing aggregate demand. Other things being equal, when demand increases, firms tend to react partly by increasing prices and partly by increasing the quantity of output.
Sometimes the economy is hit with a sudden drop in demand – a demand shock. A demand shock can be caused by a decrease in demand for exports, a downturn in consumer confidence, or a malfunction of financial markets. The result is a recession during which real output falls below its potential and unemployment rises. Inflation usually slows during a recession caused by a demand shock.
Recessions caused by demand shocks can usually be remedied by timely use of monetary stimulus (lower interest rates or other actions by the Fed) or fiscal stimulus (tax cuts or new government spending.)
In other cases, the economy may be hit by a supply shock. A classic example of a supply shock is the impact on an oil-importing country of an increase in world oil prices. Supply shocks can also cause recessions, but these recessions tend to be accompanied by a combination of rising unemployment and accelerating inflation.
Supply-shock recessions are harder to fix. If the Fed raises interest rates or the government cuts spending to fight inflation, that makes unemployment rise even more. If the Fed cuts rates or the government cuts taxes to mitigate the rise in unemployment, inflation will be worse. The best that can be achieved is a compromise between the two evils.
An even worse kind of supply shock not only causes prices to rise, but puts quantitative limits on the amount of real output that can be produced. An embargo on the sale of vital inputs to a country, such as the Arab oil embargo that hit the United States in the 1970s, or the sanctions imposed by the U.S. on Iran at present, are examples of such quantitative supply shocks.
The worst kind of recession of all happens when a country is simultaneously hit by a quantitative supply shock and a demand shock. That is what we have with the coronavirus. The supply-side effect comes from the disruption of international supply chains, aggravated by the fact that sick workers can’t do their jobs. The demand-side effect comes from the fact that sick or laid-off workers have less money to spend, and even those who are still working are afraid to travel or eat out.
There is no way to completely overcome such a double shock in the short run. Fiscal or monetary stimulus can’t cure sick workers, can’t erase overcrowding of medical facilities, and can’t restore disruptions to international trade. The best that policy can do is limit the damage.
Here are some do’s and don'ts for policymakers in reacting to a combined supply-demand shock:
- Do accept the inevitable: No matter what we do we are going to get at least a brief recession. Be honest about it.
- Don’t worry too much about inflation. If supply disruptions push up prices a little, we can live with it.
- Don’t be paralyzed by deficit fears. No matter what we do, the deficit is going to soar. But borrowing is very cheap, we can live with it.
- Do use monetary and fiscal policy together to try to keep demand from collapsing into a downward spiral.
- Don’t go overboard with stimulus – after a point, all you would get is excess inflation.
- Do keep stimulus targeted on those who need help most – unemployed workers, small businesses, etc.
- Do (of course!) take all possible steps to flatten the curve of the epidemic itself
All this is explained in more detail in the slideshow. It should make a perfect plug-in if you're switching your own courses to on-line instruction!