Why We are Likely to Need Strong Aggregate Demand Stimulus after Tight Social Distancing Restrictions are Over
Link to the Wikipedia article “Stimulus (physiology),” from which this image is taken
There are three reasons we are likely to need strong aggregate demand stimulus after tight social distancing restrictions are over.
1. First, despite efforts to compensate people for economic losses from social distancing, many households and firms are likely to reduce their spending because of increased debt they bear—and for many, from being bankrupt.
Intermezzo. The second and third reasons stem from the likelihood that the tight social distancing restrictions will not end cleanly and be over for good. Even if nationwide or nearly nationwide lockdowns are over, there is likely to be a rolling set of regional lockdowns and the coronavirus resurges in particular areas. The fear of such regional lockdowns is likely to make both investment in factories and equipment and in hiring workers seem risky.
(It is less clear that residential construction will seem risky. Lockdowns make people spend more time at home, and so may make them more eager to get just the right home, if they have the means. But it is also very possible that potential lockdowns may make people scared to build homes.)
2. Reluctance to make the at-least-partially-irreversible decision to buy equipment or build a new factory due to uncertainty about how the pandemic will evolve has a direct drag on the investment component of aggregate demand. (At-least-partially-irreversible means simply that there are costs to reversing the decision.)
3. Reluctance to make the at-least-partially-irreversible decision to hire workers could have an even more interesting consequence. It could cause a shift in the Okun’s Law relationship between output and employment, making employment lower for any given level of GDP as firms accommodate any given level of sales with fewer workers by making the workers they have work more intensely. This extra effort-per-hour is not sustainable in the long run, but can be kept up for a while. In any case, the bottom line is that aggregate demand may need to target an especially high level of GDP to get a reasonable level of employment. There would be a sense in which the potential or natural level of output has temporarily increased and the target level of aggregate demand needs to rise to meet it.
Conclusion. There are many things that aggregate demand alone cannot fix. However, to the extent aggregate demand is helpful, it is fortunate that there is no limit to how much aggregate demand stimulus the Fed and other central banks can provide by cutting interest rates, because there is no lower bound on interest rates except the lower bounds central banks choose to impose. (See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”)
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