The coronavirus and the general NZ economy

The coronavirus has been in the news, with its relatively rapid spread a cause for concern.  This has important welfare and wellbeing effects associated with the pain people might experience due to the coronavirus. 

However, today I am going to discuss how we can think about the consequences of a disease outbreak for the general economy – or in terms of broad macro stabilisation or monetary policy. 

These lessons can help us understand some of the broad consequences of a disease outbreak which can then be extended to ask other policy related questions (eg how the virus might disproportionately affect industry sectors in NZ, what areas are harm reduction policies particularly important).

Let’s consider two scenarios: 

  1. If the coronavirus doesn’t reach New Zealand ,
  2. If the virus spreads across NZ.

What is the consequence of this in terms of economic activity, and what should the monetary policy response be?

Scenario One: When New Zealand remains virus free – but the world doesn’t

If the virus doesn’t come to NZ, then we are going to experience a short-term negative demand shock.  What does this mean – it means there is less “demand” for New Zealand made goods and services. Behind this would be: 

  • fewer tourists coming from overseas , 
  • a drop in physical exports due to getting harder to trade goods and services, 
  • hurting consumer and business confidence and, as a result, reductions in how much they consume and invest. 

The damage to tourism and hospitality industries can be significant as hotels and restaurants that would normally be full are going to be empty. The virus could also disrupt NZ’s position in the global supply chain, given that China is one of our key trading partners.

I should note that, there are ways to increase demand under this scenario as well, such as precautionary purchases made by households e.g. canned food, face masks, etc. Moreover, the spread of the coronavirus reduces imports from overseas which might lead to a substitution towards domestic products. However, I would expect that the first three negative demand shocks to swamp the factors that increase demand. 

Scenario Two: The virus arrives

The second scenario asks what will happen if the coronavirus comes to New Zealand. 

Under this scenario, the demand shock described above still holds – but it is extended by the fact that people are sick and so will not go out to the shops.  As a result, the aggregate demand shock is likely to be larger.

But on top of that, people who are sick either do not go to work or at least work less.  Given the high speed of contagion of this particular virus, there will be a large number of people off sick at the same time, hence making this a noticeable short-term supply shock. 

In the unfortunate circumstances where a lot of people die, this becomes a long-term supply shock. The most important thing in this circumstance is the sadness at this loss of life, however in terms of what we are describing here we have to note that simply because there are fewer people fewer things will be made.

What should the monetary policy response be? 

We can evaluate what the central bank “should” do in the above graphs by thinking about how the left hand axis – P, or prices – changes.

Lower prices in that graph can be thought of as a situation where lower interest rates are necessary, while higher prices can be thought of as a situation where (depending on views regarding how long the shock lasts) higher interest rates are needed.  This simplifies a complex, dynamic, process – but in a way where we can try to understand why certain choices may be made.

If the coronavirus doesn’t reach NZ, then the central bank will likely need to lower interest rate due to the negative demand shock. The longer the demand shock is, the more likely it is that it could start to push up unemployment – indicating a greater need for the central bank to respond.

If it does reach NZ, then the response depends on the relative size and length of the demand and supply shocks – if people keep spending as before, but all decide to stay home from work, then lower interest rates would be inappropriate.  However, if people only stay home from work for a week or two but continue to be shy with their spending for a long time lower interest rates could be justified.

There are broader policy questions from such a shock.  What is the role of government in terms of insuring New Zealand individuals, and industries, against such shocks?  How are our responses with regards to public health associated with the social and economic risks to individuals from the virus?  What is the New Zealand public willing to sacrifice in order to mitigate/limit harm from the virus – and what is the government have a role in coordinating this?

The above framework helps to guide our initial thinking on this – but judgement calls need to be made based on ideas of insurance and coordination, the spread of a disease is not an issue an individual can internalise alone.