The Corona Shock is Different from other Supply Shocks

The coronavirus pandemic constitutes an economic shock, specifically a supply shock. In contrast to demand shocks, supply shocks cannot be offset by monetary policy. A supply shock will lead to a temporary reduction (or slow-down of growth) of output (Real GDP) and therefore a temporary reduction (or slow-down of growth) of consumption and living standards.

While the central bank is not able to prevent a supply shock from having a negative effect on RGDP, it is usually able to prevent secondary effects such as, for example, an increase in unemployment.

Supply Shocks – the Normal Case

A supply shock reduces the productive capacity of the economy. As a result workers need to accept lower real incomes. If nominal wages were fully flexible, they would adjust downwards. The number of jobs would stay the same. In reality, nominal wages are very sticky, so instead the number of jobs adjusts downwards unless the central bank keeps nominal spending stable.

If the central bank stabilizes aggregate demand (i.e. nominal spending), real wages will (as a result of price rises) fully adjust to the diminished productive capacity of the economy. Unemployment will stay the same. Only the composition of Nominal GDP (NGDP) growth will temporarily change (more inflation, less real growth).

The Corona Shock

The corona shock is also a supply shock but one which does not permanently reduce the productive capacity of the economy. Basically, the corona shock constitutes a temporary shutdown of large parts of the economy. There is, in principle, no need for real wages to adjust to a new reality of a less productive economy.

The goal should be to enable businesses which had to shut down temporarily to start right up again once health experts have given the green light for that to happen. What you don’t want is such businesses running out of cash before the restart of the economy. One way of doing this would be for businesses to put employees on temporary unemployment. The temporarily unemployed could then be supported by checks from the government or from the central bank during the time of the shutdown.

Furthermore, the central bank should make sure that businesses have access to credit to stay afloat during the shutdown. If banks don’t provide (enough of) such access, the central bank may even lend money to businesses directly.

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