Keynesian models of depression. Supply shocks and the COVID-19 Crisis

TL;DR

This paper extends Keynesian depression models to analyze supply shocks like COVID-19, comparing quantity and pricing adjustments and their policy implications, with theoretical and practical insights.

Contribution

It develops an expanded Keynesian model to analyze supply shocks, comparing two adjustment mechanisms and their effects on macroeconomic variables and policy recommendations.

Findings

Quantity adjustment leads to medium/long-term depression with higher inflation.

Pricing adjustment causes rapid short-term depression with lower inflation.

Policy measures impact inflation differently depending on the adjustment mechanism.

Abstract

The objective of this work is twofold: to expand the depression models proposed by Tobin and analyse a supply shock, such as the Covid-19 pandemic, in this Keynesian conceptual environment. The expansion allows us to propose the evolution of all endogenous macroeconomic variables. The result obtained is relevant due to its theoretical and practical implications. A quantity or Keynesian adjustment to the shock produces a depression through the effect on aggregate demand. This depression worsens in the medium/long-term. It is accompanied by increases in inflation, inflation expectations and the real interest rate. A stimulus tax policy is also recommended, as well as an active monetary policy to reduce real interest rates. On the other hand, the pricing or Marshallian adjustment foresees a more severe and rapid depression in the short-term. There would be a reduction in inflation and inflation expectations, and an increase in the real interest rates. The tax or monetary stimulus measures would only impact inflation. This result makes it possible to clarify and assess the resulting depression, as well as propose policies. Finally, it offers conflicting predictions that allow one of the two models to be falsified.