1 INTRODUCTION

Macroeconomists are struggling to come to grips with and provide a macroeconomic analysis of the COVID-19 pandemic. Currently, Keynesian-inclined economists have sought to explain the pandemic using the income–expenditure model, whereas mainstream economists have sought to explain the pandemic using the aggregate demand (AD)–aggregate supply (AS) model. In the former, the pandemic takes the form of a pure negative AD shock, whereas in the latter it takes the form of a joint negative shock to AD and AS. This paper offers an alternative interpretation in terms of a Keynesian two-sector model.

No part of the economy escapes the macroeconomic consequences of COVID-19. Reduced production in one firm affects demand for other firms’ products. Shortages in one sector lead to unemployment in other sectors. When supply is restrained in one sector it leads to reduced demand in other sectors.

The two-sector model has a long and productive history in Keynesian macroeconomics. It has been used in an open-economy context to explain economic outcomes between countries (see Dornbusch 1980, ch. 3) and to explain spillovers between sectors in a multi-sector economy (see Palley 1990). It has also been applied to developing economies (see Taylor 1991). This paper applies the two-sector model to the COVID-19 pandemic, which is interpreted in terms of a sector-specific supply shock that spills over to the rest of the economy as a demand shock. Specifically, the pandemic can be interpreted as a shock to the services sector (for example, hotels, restaurants, travel, entertainment, etc.) with such activities being closed by law or by consumers refusing to congregate as needed to purchase such services.

2 MACROECONOMICS, DEVELOPMENT ECONOMICS, AND RECENT MACRO THEORY

Bottlenecks and forced savings are not standard building blocks in describing a modern capitalist economy. However, they are classic and important topics in economies at other times and in many places. In his book Economics of Shortage (1980), the Hungarian economist János Kornai described both types of mechanism in great detail. In his discussion of the problems of centrally planned economies, and in the article ‘The measurement of shortage’ (1976), he discusses in depth shortage-forced saving.

Shortages and rationing were also an important phenomenon in the war economies in the period 1940–1945. Rationing of goods contributed to high savings in the United States during the war. Private savings helped fund the war effort, but they also proved important when peace came. At the end of the war, there was great concern in the US about mass unemployment and downturns when the war industry shut down and when demobilized soldiers returned home. Later Nobel laureate Lawrence Klein (1964) was rather optimistic. His reasoning was that, as soon as rationing ceased, consumption, which had previously been kept down, would boom. His concept of this phenomenon was pent-up demand. Nobel laureate Trygve Haavelmo worked in the Cowles Commission with Klein towards the end of the war and the discussions about such deferred consumption and forced savings certainly inspired Haavelmo in the lectures on price control and rationing he held in 1956. In chapter 4 of From the Theory of Rationing and Price Regulation by Johansen (1958, p. 21), he notes the following (our translation from Norwegian): ‘We can say that the difference between the expenditure for the originally intended quantity and the cost of the rationed quantity can be denoted as forced savings when your income is given.’

Also, in Structuralist equilibrium models for developing countries, scarcity appears as an important explanatory mechanism. This is based on a long tradition that studies how scarcity of goods restricts production and investment. Michał Kalecki (1971) was concerned that scarcity of agricultural goods limited industrial expansion, while Hollis Chenery was concerned with how scarcity of export revenue limited imports of necessary inputs and investment goods, thereby hampering growth (see for example Chenery and Bruno 1962). As the chief economist of the World Bank, Chenery in the 1970s used such reasoning as an argument for foreign aid. In Structuralist equilibrium models, this problem is sometimes referred to as import compression. In these models, prices are not able to balance supply and demand in all markets, and rationing has economy-wide effects. An example is Davies et al. (1994). In this description of Zimbabwe's economy, import compression leads both to lower investment and lower production. In addition, rationing of consumption goods increases private savings.

Disequilibrium models were also central to macroeconomics for capitalist economies. Here, models were developed where prices did not adjust to achieve equilibrium in the markets, often referred to as fix-price models. These models may exhibit disequilibrium with rationing in some markets, for example in the labor market, while they can be at equilibrium in others. Barro and Grossman (1976), Malinvaud (1977), and Bénassy (1982) delivered important contributions to this area of macroeconomics, which is also very relevant during the COVID-19 crisis.¹

We also find similar mechanisms from the literature above in recent macroeconomic theory for developed market economies, albeit in models based on a somewhat different tradition. A dominant field of research is linked to so-called New Keynesian models, where the agents are assumed to be more rational and forward-looking than in traditional Keynesian models, but where there are nominal rigidities so that production is not always at its equilibrium level. Lately, these models have been modified to have some features that make them even more similar to the traditional Keynesian models. For example, under the assumption of imperfect credit markets, consumption will not depend on permanent income and real interest rates only, because some consumers will be rationed and only consume current income. From this assumption, it follows directly that current income also plays a role in aggregate demand. See, for example, Debortoli and Galí (2018) and Kaplan et al. (2018).

There are also examples of recent macro models that directly study the effects of the COVID-19 crisis, although none of these, as far as we have seen, point out that the mechanisms discussed are very similar to those previously studied in the macro literature of developing countries. The paper that most closely resembles ours is Guerrieri et al. (2020). These authors show that several of the results that we find in our simple model can also be valid in more recent types of macro models, as long as these are extended to allow for more than one sector.

In the following, we aim to discuss how some of the mechanisms from traditional macro literature, from development economics and also from more recent macro literature, can impact the economy and economic policy in the time of COVID-19. We have chosen to do this by extending well-known model frameworks. This, hopefully, makes the analysis also available to students and to economists who do not have macroeconomics as their research field.

However, our choice of model framework comes at a cost. The literature referred to is much richer in mechanisms than the ones we address. And our presentation of the mechanisms, embedded in well-known frameworks, does not do justice to the literature. In addition, we look at economics and politics during the crisis. Mechanisms that are relevant in the longer term – that is, after the crisis – may be different and are not addressed here. Particularly important are hysteresis effects. If the crisis is deep and long-lasting, it can be very difficult to avoid having permanent effects in the form of lower production and higher unemployment. The steady state of an economy is not something that should be viewed as exogenous, as much of current macro theory implicitly assumes when focusing on fluctuations around a given steady state.

In order to discuss how the crisis affects demand and supply, we use the simplest Keynes model, and show how this can be modified by incorporating crisis mechanisms. We then use this modified model to discuss the impact of fiscal policy during the crisis.

3 A SIMPLE MODEL IN THE TIME OF COVID-19

We start from the premise that during the time of COVID-19, government restrictions constrain the production of some goods and services. These goods and services are limited from the supply side, while others may be limited from the demand side. We let Y₂ denote the total production of goods and services that are directly affected by virus prevention measures (full or partial), while Y₁ is the production of goods and services not directly affected by prevention measures.² For ease of exposition, we refer to Y₁ as goods and Y₂ as services. In order to keep things simple, we abstract from intermediate deliveries between sectors. This is innocuous as long as we assume that only final deliveries are directly affected by government restrictions.³

This is also illustrated in Figure 1. Here, a q larger than zero is captured by the curve D′₂. An increase in q makes part of the consumption demand directed towards services unsatiated. As a result, the activity in services drops. The services sector is now partly supply-constrained. The immediate consequence of the supply constraint is that production of services drops from the initial equilibrium. When demand repercussions within services is also accounted for, it leads to a drop down to point A in the figure. This vertical distance is a measure of the extent of supply constraints in services, when demand repercussions via the goods sector is not accounted for. But lower activity in services lowers demand towards goods. Due to demand multipliers, goods production shrinks further down to the new equilibrium where both Y₁ and Y₂ are lower. The new equilibrium is point B at the intersection of the D′₂ and D₁ curves.

Hence, services is hit twice. First, as parts of it are shut down. Second, as the economy contracts, the services that still operate suffer a demand contraction. The demand repercussions to services via the goods sector is less than in the unconstrained case, however, as can be seen from (2), the slope of D′₂ is less than the slope of D₂. Hence, services production reacts less to the drop in goods production when some services cannot be delivered.⁵

As we have seen, the drop in aggregate income exceeds the drop in income due to the restrictions in services. Guerrieri et al. (2020) define a supply shock that decreases aggregate production by more than the shock itself as a ‘Keynesian supply shock.’ Of course, in development economics such a result is rather standard, for instance, with a drought, aggregate production drops by more than the fall in agricultural output.

In addition, the supply constraints may affect other demand components as well. NX₂ and I₂ may drop as service supply for these purposes is halted, or because the crisis has additional effects on demand to those analysed above. The effect of such drops is captured by the variable ∆ and is represented in Figure 1 by the vertical shift from D′₂ to D″₂. In this case the new equilibrium ends up in C at the intersection of the D′₂ and D₁ curves. Also in this case there are multiplier effects between the sectors.

Partial COVID-19 shut down of sector 2

Citation: Review of Keynesian Economics 9, 2; 10.4337/roke.2021.02.01

So far, we have focused on the shutdown of parts of sector 2 and its impact on income and consumption demand. Investments can also be expected to be hit hard. The reason is that investments are complex activities where each project requires input from both sectors. If there is such a strong complementarity, we get the classic problem of developing countries, where investment will be paralysed by certain essential goods or components not being available. Often, the restriction is linked to the investor's access to currency. When there is such a strong complementarity between the elements, the shutting down of parts of sector 2 may completely end all investment demand directed towards sector 1. The ability to invest is gone at the same time as the desire to invest is reduced. This represents a demand shock that hits the remaining activity in sector 1 hard. It comes at the top of the mechanisms via consumer demand and multipliers, and provides a further need for public countermeasures.

4 CONCLUDING REMARKS

In the analyses above, where there is full employment and capacity utilization before the crisis occurs, it is impossible for the policy to ensure balance in the economy when the crisis occurs. No matter how powerful the sum of fiscal and monetary policies is, the decline in activity levels and the rise in unemployment cannot be fully offset. The reason is that part of the economy is directly restricted from the supply side by political decisions motivated by limiting the spread of the virus. The best one can achieve, as regards stabilization policy, is to correct for the indirect demand and supply effects.

In a time of crisis, it may make sense for economists to supplement the model types they usually work with. For developed market economies, there may be much to learn from economies in crisis at other times and in other places. Both historical analyses of non-market economies, and analyses that study economic mechanisms in developing countries, contain well-developed insights for analysing the crisis we are in, as well how economic policy may work during such a crisis. It is easy to become too preoccupied with the most recent advances in economic models, and to get too caught up in the present consensus. But it is also important to look for established insights that have proven relevant in similar crisis situations. We should recognize that analyses that the economics mainstream profession do not usually see as relevant can bring lessons into a new, and for the mainstream economic profession, unfamiliar time.