
Can negative supply shocks cause demand shortages? [pdf] - wallflower
https://www.nber.org/papers/w26918.pdf
======
downerending
I wonder how this plays out in the real world. Restaurants have suddenly
become unavailable, my demand for them has dropped precipitously, they become
available again, but I don't see myself reverting to my prior demand for
years, if ever.

Abstract:

 _We present a theory of Keynesian supply shocks: supply shocks that trigger
changes in aggregate demand larger than the shocks themselves. We argue that
the economic shocks associated to the COVID-19 epidemic—shutdowns, layoffs,
and firm exits—may have this feature. In one-sector economies supply shocks
are never Keynesian. We show that this is a general result that extend to
economies with incomplete markets and liquidity constrained consumers. In
economies with multiple sectors Keynesian supply shocks are possible, under
some conditions. A 50% shock that hits all sectors is not the same as a 100%
shock that hits half the economy. Incomplete markets make the conditions for
Keynesian supply shocks more likely to be met. Firm exit and job destruction
can amplify the initial effect, aggravating the recession. We discuss the
effects of various policies. Standard fiscal stimulus can be less effective
than usual because the fact that some sectors are shut down mutes the
Keynesian multiplier feedback. Monetary policy, as long as it is unimpeded by
the zero lower bound, can have magnified effects, by preventing firm exits.
Turning to optimal policy, closing down contact-intensive sectors and
providing full insurance payments to affected workers can achieve the first-
best allocation, despite the lower per-dollar potency of fiscal policy._

~~~
zozbot234
> Restaurants have suddenly become unavailable, my demand for them has dropped
> precipitously, they become available again, but I don't see myself reverting
> to my prior demand for years, if ever.

That's not considered a _demand_ shortage in this context, because you're not
necessarily holding on to more cash (the medium of exchange) simply because
you've stopped going to restaurants. You might be dispensing of your cash in
other ways.[0] It's a negative supply shock that's confined to the restaurant
sector.

[0] (Yes, there is a multiplier effect but it goes both ways. The multiplier
effect is a result of agents trying to keep to their preferred level of cash
holdings while facing an outside change in the amount of monetary spending.
It's really a "hot potato"/"frozen potato" effect: if agents are suddenly
giving you more cash you'll want to spend the excess, and if no one is giving
you any money you'll seek to restore your balance either by seeking cash from
others or by curtailing your own spending.)

~~~
downerending
I'm not an economist, but I actually _am_ holding onto the cash (putting it in
savings). Yes, I'll probably ultimately spend it on something else but not for
decades.

~~~
zozbot234
Unless you're literally buying government bonds (that are yielding very low
and sometimes negative returns) your savings will still translate to increased
spending elsewhere.

~~~
downerending
I googled for a bit and wasn't able to find a definition for "demand shortage"
specifically, so I can only guess at what it means, versus the intuitive idea
that "restaurants expected a certain level of demand, and those expectations
have been dashed".

Does anyone understand the exact point being made?

~~~
zozbot234
I think the established terminology is more like "demand shortfall". In a
general (non-sector-specific) economic context, this almost always refers to a
fall in demand for _all_ goods or services that introduces severe frictions
into the workings of the market mechanism itself, and that can thus be
"solved" in a comparatively straightforward way by addressing these frictions.

The "liquidity constraints" discussed in the abstract may be one such
friction, but it's quite common for agents to be liquidity-constrained or
unwilling to incur debt even irrespective of any negative supply-shock, so
it's not quite clear to me what points the paper is trying to make.

~~~
downerending
Whelp, I guess that's why I call myself an amateur. Thank you for your
attempt. :-)

------
tropdrop
This is a quick sum of the study's basic intuition:

> _When workers lose their income, due to the shock, they reduce their
> spending, causing a contraction in demand. The question is whether this
> mechanism is strong enough to cause an overall shortfall in demand._

Answer:

> _Positive, demand may indeed overreact to the supply shock and lead to a
> demand-deficient recession._

Suggested solution:

> _The optimal policy to face a pandemic in our model combines a loosening of
> monetary policy as well as abundant social insurance._

~~~
Hokusai
> loosening of monetary policy

The federal funds rate is zero. So, direct injection of money seems the only
way forward. Direct injection failed massively in the last recession where
money was given to the markets but failed to reach the consumers. There is a
lesson to learn there.

Europe approach in the current situation is to pay companies to keep citizens
employed in combination with it’s already existing social protections. USA
approach has been directed to assure companies capital to keep them for
failing. The pandemic is an awful situation but a very interesting economic
experiment. Time will tell the pros and cons of the different approaches.

~~~
zozbot234
Monetary loosening did _not_ fail post-2008 recession, except to the extent
that it wasn't really tried in the first place. Whenever aggressive monetary
loosening was done, even by unconventional means, the market responses in the
forex, stock and even in the bond markets were very clear. (Contrary to common
misconceptions, loose monetary policy should _not_ be expected to cause low
rates in e.g. the bond market; low market rates occur when money has been too
_tight_ , and interest-rate based monetary policy works like stabilizing an
_unstable_ system, so pushing market rates higher requires setting the
_policy_ rate even lower!)

~~~
nostrademons
That I think was his point: we did see large responses in asset prices, but
this excess money going into the forex/stock/bond markets did not trickle down
into the labor market like conventional economic theory assumes it would.
Instead of stimulating the real economy, it led to asset bubbles and widening
income inequality.

~~~
zozbot234
Excess money does not go "into" markets, it flows _through_ markets and into
private-sector balances. And excess money is not what you think it is anyway:
when bond-market returns are low due to tight monetary policy in the past, the
demand for cash and cash-like instruments is sky-high and the monetary
authorities need to create even more excess money to satisfy it. This is
pretty much non-negotiable: if you want to avoid this kind of conundrum, you
should avoid tight policy in the first place. (High asset prices are simply
the flip side of _low_ returns for bond-like instruments.)

~~~
nostrademons
So that's all technically correct, but the point I'm making is that as that
excess money is flowing _through_ asset markets, it's ending up on the balance
sheet of private-sector actors who have little need to spend it on a day-to-
day basis anyway. In Keynesian terms, money is pooling at precisely those
firms who have a low MPC (which is not coincidental: it pools at those firms
_because_ they have a low MPC, because pooling indicates a high MPS). Thus the
government needs to inject much more money through these markets than it
expects, because the Keynesian multiplier is low. In the process, it inflates
the paper wealth of these firms significantly more than it actually stimulates
the real economy, something we saw from 2010-2020.

I think the OP is alluding to the strategy of giving money directly to
consumers, and particularly poor consumers (who tend to have a high MPC). This
limits the pooling effect: it still happens, but it can't happen until the
money has circulated throughout the economy a few times, which increases the
stimulus effect for a given amount of inequality generated. As an added
benefit, the effects are more immediate, which helps the central bank
understand the consequences of its actions more rapidly and not have to act 18
months or so in advance of when the stimulus trickles down to real production.

~~~
zozbot234
If you want to do this kind of policy by directing money flows in a non-
neutral way, the highest-impact policy by far is subsidizing investment.
Investment spending reacts very aggressively to any change in forecasted
returns, far more so than would be implied by differential MPC. (A policy of
giving more money to the poor is highly desirable for _other_ reasons; e.g. it
directly addresses liquidity constraints. It's sensible to regard these as
distinct issues, however.) At the moment, the Fed is paying interest on excess
reserves, which is quite bad if you think there's too little demand and we
should have more investment. That's one way of saying that policy might have
been too tight even post-2008.

------
ouid
The pandemic is not primarily a supply shock. It is primarily a demand shock.
People aren't going outside.

~~~
danans
> The pandemic is not primarily a supply shock. It is primarily a demand
> shock. People aren't going outside.

That it's not primarily a supply shock (all kinds of products and raw
materials are just as available as they were before the pandemic) is yet
another indicator of the impact increased automation and labor efficiency in
manufacturing has had. It's remarkable - and a bit frightening - how little
human labor is required to provide a sufficient supply of goods to a huge
number of people.

~~~
erik_seaberg
We aren't providing sufficient goods. We're consuming a backlog that was
already produced and waiting, and that won't last.

~~~
JshWright
If you're suggesting there were several months worth of backlog prior to
COVID-19, that would imply pretty massive inefficiencies...

~~~
TeMPOraL
There weren't; if there were, we wouldn't be in half as much of a bad shape as
we're now. "Inefficiencies" is just a greedy optimizer's word for "safety
margins", "redundancies" and "buffers". But we're living in a word run by
greedy optimization.

We're not consuming buffers (those were all cut long ago as "fat"), we're just
lucky that the people responsible for logistics - who are right now forced to
fly by the seat of their pants - are still managing to route goods around well
enough for us to not notice, beyond an occasional shortage or price hike.

------
jb775
I think the public narrative not being kept congruent with actual supply
levels is the main factor at play here. If everyone's talking about a shortage
of toilet paper, you initially rush out to buy extra toilet paper, but can't
find any. You continue to see dialogue of "toilet paper shortage", and figure
it's not even worth the effort to walk down that aisle, but for all you know
your local store is fully stocked.

~~~
perl4ever
The grocery store I go to has had limits on paper towels, toilet paper, flour,
etc. to one per customer per day for I think months and that seems to have
solved the problem.

The choices of flour were briefly very limited, but now there's pretty much
anything I'd want.

------
bachmeier
If you want to see Ivan Werning's presentation:
[https://www.youtube.com/watch?v=-PkK9IlTHVM](https://www.youtube.com/watch?v=-PkK9IlTHVM)

------
lionhearted
Quick take on a first skim and thinking:

1\. Looks interesting. Worthwhile type of thinking.

2\. Control+F "savings" / "saving" ... no results. You'd think that the amount
and distribution of savings in a population would greatly effect the outcomes.

That said, "elasticity" showed up 14 times in a control+f of the paper so it
might be implicitly covered or named differently.

Edit: "reserve" / "reserves" had no relevant mentions (1x "rights reserved",
2x in citations of Federal Reserve), capital 0 mentions, "insurance" 14
mentions, "ability" 0 mentions, "willing" / "unwilling" / "willingness" 1
mention total, "substitute" / "substitution" 19 mentions, "bankrupt" /
"bankruptcy" 0 mentions, "unemployment" 11 mentions, "funds" 0 mention, "cash"
0 mentions, "money" only 1 mention (!)... "monetary" shows up 20 times though.

Edit2: Lots of "utility function" going on. I personally don't really love the
theoretical grounding of utility functions but it might actually produce
interesting insights in this case.

Edit3: "Each agent is endowed with n > 0 units of labor which are supplied
inelastically" \- inelasticity of units of labor in this case seems like a
pretty aggressive assumption. They carry that assumption through - "As before,
agents inelastically supply labor n to their respective sector in the flexible
price equilibrium; they may supply less than n in the equilibrium with wage
rigidities. For now, we assume that workers are perfectly specialized in their
sector."

Quite theoretical with a fair amount of simplifying assumptions to make it
simpler to mathematically model. The conclusions are rather tentative and not
strongly stated, in any event. Interesting line of thinking, I think you'd
have to look closely at the assumptions and premises and how variables are
defined to see if it corresponds well to real life.

~~~
jmalicki
Savings is implied through extensive discussion of marginal propensities to
consume (MPC) - the fraction of additional income that a person will NOT save.

~~~
lionhearted
That's right, yeah.

But here's what they're investigating:

> ”In this paper, we introduce a concept that might be accurately portrayed as
> “supply creates its own excess demand”. Namely, a negative supply shock can
> trigger a demand shortage that leads to a contraction in output and
> employment larger than the supply shock itself."

They've got some time variables; I think an explicit savings variable (and
maybe credit, too) would be important in determining whether that'd happen.

I might be mistaken, I tossed some quick thoughts up when this had zero
comments, looking at methodology and assumptions moreso than conclusions. But
you'd think regions with high-savings, low-savings but lots of credit, and
low-savings combined with low credit would behave very differently towards "a
contraction in output and employment larger than the supply shock itself."

Math gets way more complicated as you addd variables like that, though, and
maybe it wouldn't effect the conclusions too much though, so... ¯\\_(ツ)_/¯

~~~
jmalicki
Also see section 5.4. They use the word liquidity rather than saving - it's
not being obtuse, just highly technical vocabulary.

" What happens if firms are liquidity constrained? If firms have some finite
amount of liquidity at their disposal, say, because they cannot borrow nor
issue equity and have limited past accumulated profits at their disposal, then
they no longer maximize the present value of profits in an unconstrained
fashion. This distorts firm decisions towards laying workers off, since the
current period loss cannot be financed."

