Combined Negative Demand and Supply Shocks

The Covid-19 pandemic recession lasted, according to the NBER, two months (March and April 2022). It was the deepest recession since WWII and was caused by a combination of negative supply and demand shocks brought about by the lockdowns in early 2020. The repercussions where felt across the economy. In this exercise we will use the model presented in class to understand how the economy would have reacted to these negative shocks had the government and Federal Reserve not done anything about it.

1. Negative Supply Shock

Let us study first how the recession would have taken place if the only driving force had been a negative supply shock caused by supply chain issues, but demand had not dropped. This could be for instance the case of Taiwan, where COVID-19 was very controlled and life for most citizens continued as normal, but due to lockdowns in other countries, they faced lack of components and a rise in prices of imported parts and goods. These supply chain disruptions meant higher costs of production and a negative supply shock.

Explain using the model (draw the graphs for the 3 markets) and words what would have happened to the main macroeconomic variables in the economy if the COVID-19 pandemic recession would have been caused only by a temporary negative supply shock. (35 points)

1. Negative Demand Shock

Let us analyze now the recession if it had only been caused by a negative demand shock. Imagine for instance the situation lived in many countries after the start of pandemic in other countries but prior to their own lockdowns and the supply chain disruptions. Seeing what was taking place in other countries, it could have been evident that things were going to get bad as soon as COVID spread in their country. Many businesses and individuals in these countries where COVID arrived late may have seen the negative economic effects of lockdowns and foresee that their economy would also suffer from output decline, job losses and decline in wages. This, while still not happening it that particular economy, could have made households and firms lower their consumptions and investment in preparation for lower future income, which would have meant a negative demand shock.

Explain using the model (draw the graphs) and words what would have happened to the main macroeconomic variables in the economy if the COVID-19 pandemic recession would have been caused only by a temporary negative demand shock. (35 points)

b. Combining both Negative Supply and Demand Shock

Finally, let us look at what happened in the U.S. (excluding the policy reaction to the shocks) which was a combination of both a negative supply and demand shocks. Let us assume that the negative supply shock was bigger than the negative demand shock (the shift to the left of the supply curve is more pronounced than that of the demand curve for the goods market).

Explain using the model (draw the graphs) and words what would have happened to the main macroeconomic variables in the economy if the COVID-19 pandemic recession would have been caused only a simultaneous a temporary negative supply and demand shocks, where the negative supply shock is stronger than the demand one. (30 points)