The scars of supply shocks

Abstract

We study the effects of supply disruptions - for instance caused by the emergence of a pandemic - in an economy with Keynesian unemployment and endogenous productivity growth. By negatively affecting investment, even purely transitory negative supply shocks generate permanent output losses. The associated negative wealth effect depresses consumers’ demand, which may even fall below the exogenous fall in supply. In this case, the optimal monetary policy response flips relative to conventional wisdom, as monetary expansions are needed to fight negative output gaps. If monetary policy is not expansionary enough a supply-demand doom loop emerges, causing a recession characterized by unemployment and weak productivity growth. Innovation policies, by fostering firms’ investment, can restore full employment and healthy growth.