As I wrote before, the corona shock constitutes a supply shock. Normally, a supply shock reduces the long-term productive capacity of the economy resulting both in reduced output and inflationary pressure. Hence Bryan Caplan was wondering on Twitter why nobody is talking about stagflation:
I haven't heard any other economists predicting stagflation and price controls in 2021, but I can't figure out why. https://t.co/It6SZ4HJd4
— Bryan Caplan (@bryan_caplan) March 18, 2020
I replied on Twitter already but want to provide a more thorough discussion of the topic here.
The corona shock is different from other supply shocks because, in principle, it does not need to result in reduced long-term productive capacity. Basically, the corona shock constitutes a deliberate temporary shutdown of large parts of the 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. The long-term productive capacity of the economy will only be hurt, if businesses that needed to shut down go bust before the economy is turned on again.
Since the corona shock does not permanently reduce the productive capacity of the economy, there is no need for real wages to adjust and hence no need for rising prices. That’s one part of the answer.
For the rest of the answer consider the economy as a whole. Let’s say 20% of the economy is shutdown by public-health mandate, voluntarily or because of a break-down of supply chains.
If NGDP in the economy (under normal circumstances) is roughly 20 trillion USD, this means that the NGDP produced by the part of the economy that is still running would, under normal conditions, amount to roughly 16 trillion USD (= 80% x 20 trillion USD). Let’s call the NGDP produced by the running part of the economy NGDP_r and the NGDP produced by the other part of the economy NGDP_h (whereby “h” stands for “hibernation”).
Under normal conditions we would have NGDP_r = 16 trillion USD, NGDP_h = 4 trillion USD and therefore NGDP = NGDP_r + NGDP_h = 20 trillion USD.
Under shutdown, NGDP_h obviously equals 0 USD. But what will happen to NGDP_r? The development of NGDP_r (= nominal spending on products and services produced by the part of the economy that is still running) determines how prices will develop. If NGDP_r increases, there will be inflationary pressures. If NGDP_r shrinks, there will deflationary pressures. If it stays at roughly 16 trillion USD, neither inflationary nor deflationary pressures will arise.
Intuitively, one will probably expect nominal NGDP_r to shrink. After all, a sizeable part of the population has just lost their sources of income. But intuition is not what matters. What matters is monetary policy because monetary policy controls nominal spending in the economy.
In normal times, monetary policy can (by reducing the real interest rate) counterbalance or at option outweigh any negative effect on NGDP_r resulting from the shutdown. That is, in normal times NGDP_r may grow or shrink or stay the same – depending on the objectives of the central bank.
However, we do not live in normal times. Nominal interest rates have been close to or at the zero lower bound (ZLB) for a decade. Reducing real interest rates (enough to significantly boost nominal spending) by simply adjusting the nominal rate downwards no longer works. In order to boost NGDP growth at the ZLB, the central bank has to commit to temporarily higher inflation (NGDP growth) in the future.
But since the central bank’s inflation targeting regime cuts off this route to boosting NGDP at the ZLB, NGDP_r is likely to fall during the shutdown.
Hence, the hit to Real GDP caused by the corona shutdown will most likely be accompanied by (moderate) deflationary pressures. Stagflation (reduced RGDP accompanied by higher inflation) is not on the table.