Keynesian Supply Shocks and Hayekian Secondary Deflations
Abstract: In response to the COVID-19 lockdown policies, Guerrieri et al. (2020) developed a new concept: the Keynesian supply shock. A Keynesian supply shock is an aggregate supply shock that leads to an even larger aggregate demand shock. This paper suggests that Keynesian supply shocks are very similar to the secondary deflations suggested by Hayek (1931), and US data from the 2007–09 financial crisis show that these concepts may help to explain employment dynamics in the midst of a crisis. This fact implies that long-standing policy advice based on Austrian business cycle theory would be useful in responding to Keynesian supply shocks.
JEL Classification: E32, B53
Lucas M. Engelhardt ([email protected]) is an associate professor at Kent State University’s Stark campus and a fellow of the Mises Institute.
The economic impacts of COVID-19 and the policies surrounding it have provided the grounds for extensive work in economics, especially surrounding public policy responses to the pandemic. Much of this work (for example, Eichenbaum, Rebelo, and Trabandt 2020) is based on integrating epidemiology models into standard models of macroeconomic activity. However, one exception to this trend is the introduction of a seemingly new, and possibly more generalizable, idea: “Keynesian supply shocks” (Guerrieri, et al. 2020). Keynesian supply shocks are shocks to aggregate supply that, in turn, lead to a shock to aggregate demand that is even larger than the original supply shock, so that the demand shock dominates the macroeconomic dynamics. Put another way, a Keynesian supply shock is a supply shock with a traditional demand-side multiplier. This new concept calls into question the separability of aggregate supply and aggregate demand.
This paper suggests that there is a significant conceptual overlap between Keynesian supply shocks and Hayek’s concept of a “secondary deflation,” in which an initial crisis focused on the liquidation of malinvestments leads to economy-wide consequences (Hayek 1931). If the two concepts are related, then the work on Keynesian supply shocks provides an additional approach that Austrian business cycle theorists can draw from for empirical illustrations, and Austrian business cycle theory has implications for policy prescriptions when dealing with the resulting recessions. Because Keynesian supply shocks are a new concept, there is very little literature directly connected with them yet. This paper serves as an early attempt to bring this concept into contact with the much older Hayekian “secondary deflation.”
In addition to explaining the theoretical overlap between Keynesian supply shocks and Hayekian secondary depressions, this paper will show that employment data from the United States during the 2007–09 financial crisis is more consistent with the Keynesian supply shock/Hayekian secondary deflation theory than is employment data from the 2020 COVID-19 lockdowns, which inspired Guerrieri et al. (2020) to develop the Keynesian supply shock concept. This observation suggests that these two concepts have an applicability that is not bound by the rather odd case of the COVID-19 crisis.
“KEYNESIAN” SUPPLY SHOCKS
What is a “Keynesian supply shock”? In short, a Keynesian supply shock is a supply shock that causes a decrease in aggregate demand that is larger than the original supply shock (Guerrieri, et al. 2020). If we think in terms of standard aggregate supply–aggregate demand analysis, a Keynesian supply shock would create a leftward shift in both aggregate supply and aggregate demand, with the aggregate demand shift dominating. The result is a more severe recession than either shock alone would have caused, but also a decrease in the price level. As a result, if analysts casually observe price levels and real gross domestic product (GDP) levels, they will conclude that an aggregate demand shock was the primary force driving macroeconomic dynamics, when in fact the underlying cause of the demand shock is the shock to aggregate supply.
The motivation for the idea of a Keynesian supply shock was the shutdown of nonessential businesses in many places in the world during the coronavirus pandemic, especially during the early phases (for example, Michigan’s Executive Order 2020-42, which closed all in-person work which was “not necessary to sustain or protect life”). Guerrieri et al. (2020) find that, under specific conditions, the partial shutdown of supply can lead to a demand shock that is more severe than the direct impact of the supply shock itself.
Guerrieri et al. (2020) model the shutdown as a temporary decrease in labor supply, and judge whether the aggregate supply or aggregate demand shock dominates by considering the effect on the natural rate of interest.1 In their model, the discount rate is kept constant so that the natural rate of interest will vary because of changes in the marginal utility of consumption. If the marginal utility of consumption for the present period rises relative to the expected future marginal utility of consumption, then the natural interest rate rises (consistent with the argument of Böhm-Bawerk ), which is interpreted as being consistent with the dominance of the aggregate supply shock, because the relatively high marginal utility of present consumption indicates that there is a significant unsatisfied demand for present consumption goods. On the other hand, if the marginal utility of consumption for the present period falls relative to the future marginal utility of consumption, then the natural interest rate falls, which is interpreted as being consistent with the dominance of the aggregate demand shock.
First, they consider a case in which there is a single sector which is partially shut down by lockdown orders.2 Here, one can consider a number of ways that the results could work out. First, the decrease in available consumption goods would tend to increase the natural rate of interest, as consumers expect an increase in consumption in future periods when the shutdown ends, leading to a relatively higher marginal utility of (relatively more scarce) current consumption when compared to the marginal utility of (relatively more abundant) future consumption. Looking at the phenomenon from another angle, the shock to labor supply would lead to an increase in equilibrium wages. In terms of total income, the increase in wages would at least partially offset the decrease in employment, so that there is not much of a decrease in aggregate demand—leading supply effects to dominate. The only exception is if laid-off workers decrease their consumption in proportion with their lost income, in which case the supply shock is matched by an equal demand shock such that the natural rate of interest is unchanged. However, this is unlikely in reality because laid-off workers tend to borrow or spend from their savings in anticipation of an improvement in labor markets when the shutdown ends, in addition to partaking of any unemployment insurance or other government relief measures that are likely to be made available (such as that provided by the 2020 Coronavirus Aid, Relief, and Economic Security [CARES] Act in the United States.3 In brief: if the entire economy is a single sector which is partially shut down by lockdowns, supply shocks are not “Keynesian”—they do not lead to significant shocks in aggregate demand. Notably, modeling the economy based on a “representative firm”—which effectively treats the economy as a single sector—is a common practice in mainstream macroeconomics.
However, in a two-sector economy, the story changes. In this version of the model, employees completely specialize in one of two sectors, and the shutdown affects just one sector (the “nonessential”), leaving the other (“essential”) sector to operate as usual. So, consumers are forced to go without the products of the nonessential sector but can continue consuming from the essential sector as normal. In this case, what happens to demand depends on two parameters: the parameter that governs consumers’ willingness to substitute consumption across time, and the parameter that governs the relationship between the goods produced by the two sectors. First, the more willing people are to substitute consumption across time, the larger the negative impact on the essential sector will be—as those workers that are laid off when the nonessential sector shuts down simply wait to consume until later periods. Second, if the goods from the essential sector and the nonessential sector are complements in consumption, then a negative impact on aggregate demand arising from the supply shock is more likely. Since the good from the nonessential business is no longer available, people have less demand for the complementary good from the essential business. In short, the loss of the nonessential good decreases the current marginal utility of the essential good, which can drive down the natural interest rate. If, on the other hand, people are not willing to substitute consumption across time and the two goods are substitutes, then consumers will tend to significantly increase their demand for the essential good to maintain current overall consumption during the lockdown, so that the supply shock does not create a “Keynesian” ripple effect on aggregate demand. Put another way, when the goods are substitutes, the loss of one good increases the marginal utility of the other—leading to a higher natural interest rate, reflecting the dominance of the aggregate supply shock.
The above applies in the model which assumes “complete markets” (that is, markets where workers have unemployment insurance or largely unconstrained credit, so that any fall in current consumption is divided equally among workers). Once the fact that markets are “incomplete”—that is, that lost income is mostly going to be experienced by those that are laid off because of the shutdown policies—is accounted for, the conditions that lead to decreased aggregate demand are widened. That is, some scenarios that would lead to “standard” supply shocks if markets were complete end up with significant Keynesian demand ripples because of th
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