Is COVID-19 just a supply shock?

In this post I want to have a bit of a brainstorm around the real shock we are facing with COVID-19 in the country. The key idea I wanted to think about was what type of shock this is – a supply shock, demand shock, or both!

Note that this is a public health crisis – and I recognise that these issues take precedence. But it is still important to think through the economic consequences, at least to understand what they are.

Three compelling tweets make the case for why the focus should be on supply, demand, or on some combination of both:

In this post I want to show why all the tweets are right, but relying too much on one of the perspectives would be misleading.

What are these shocks?

To clarify the ideas I think it is useful to consider two cases here:

  1. Due to illness or quarantine, it’s either more expensive or impossible to produce something. That is a supply shock
  2. Due to illness or quarantine, people don’t want to buy things that are available (e.g. fear of catching disease, uncertainty about losing a job, and people from overseas not buying from us). This is a demand shock

I’ve discussed these before and stated that:

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.

So given both shocks occur how can we think about combining them?

What about a combined approach?

Separating the shocks into demand and supply was useful to start with.  But when trying to understand the onshore pandemic alone it can become unhelpful.

As Chris Edmond states in the third tweet above, the pandemic isn’t really just a “supply shock” as factor prices aren’t rising – after all do we see wages climbing?  As a result, there is a demand element

The clearest way to thinking through this is in the tweet thread below:

Rowe makes a very clear argument here “But when hairdressers and their customers don’t want to meet each other (or aren’t allowed to) which is it?”

And I really like his idea of distinguishing between the real shock and a monetary shock. Under real shock for instance we face a real drop in hairdressing services and the utilisation of hairdressers (supply side), and the monetary shock where the customers hoard the expenditure until the service becomes available, leading to a further drop in aggregate demand at the given price level. 

However, it could be that people might be willing to substitute the hairdresser service with a completely different online service, which would give an opposite monetary effect – or financial markets may function allowing a loan to hairdressers.

In the current situation substitutes are few, and financial markets are clogged up, creating monetary consequences from a real shock – namely, even if we only viewed this part of the crisis as a supply shock, the demand side matters!

Even when there is a temporary planned shutdown of the economy demand based policies have a role – the role just isn’t to get output back to where it was, which is either impossible or undesirable in any case!

Instead the role is to prevent declines in prices, provide certainty about future prices, and prevent unnecessary unemployment of potentially useful resources. I’ll return to this point again in my next post.