Covidonomics : A Simple Parable - By Lord Meghnad Desai

Posted on: 2020-09-09 16:07:48
The impact of the Covid pandemic has been unanticipated but severe and global. Economists are familiar with situation where faced with a slump in demand, production declines, machines are idle and there is unemployment. In such cases, we know that the economy will settle at some underemployment equilibrium. Keynesian Policy then says stimulate demand to elicit supply. The economy will move back to full employment equilibrium. Or, if you like, wages will fall till unemployment is eliminated and full employment is restored. Either way, the shock can be dealt with endogenously. The Covid pandemic has also led to idle factories and decline in output and high unemployment. But this is not due to a demand shock but a supply shock of a kind previously unknown. Covid has prevented supply side functioning because of the requirement of social distancing. Consumption is similarly affected. Machines are idle because workers cannot be near each other as required for production. Indeed the supply ‘chain’ has to be broken up. Demand stimulus is not enough to revive production. There has been a severe shock of between 20 to 40% to output. One way to understand this is to use an analogy with sport. Tennis or golf do not require close contact between players. Rugby does. Certain parts of the economy are like heavy contact sport. Proximity of workers is vital. It is literally a supply ‘ chain’. Machines are idle not because demand is not there, but production is not possible as people cannot be allowed to be close to each other. Other parts of the economy can continue production because social distancing is not an issue. There are similar chains in consumption. People can drink solo but prefer to go to pubs. Theatres and cinemas also need crowds of people to make the experience enjoyable. Consumers’ utilities are interdependent. On the other hand you can shop in person or online. Here is a simple example to illustrate the impact of distancing on aggregate output. The economy has two sectors 1 and 2. There are two workers in each economy. Here are their details. Sector 1. The production function is as follows. Y1 = a N1 There are two workers and we assume a=50 units of output Y1. The total output of Sector 1 is 100. Of this output, half is consumed by the two workers and the rest is exchanged. Sector 2 has also two workers. The production function is Y2 = b **N2 We assume b=10. With two workers the output is 100. Once again we assume that workers consume half the output and exchange the other half with Sector 1. Price is 1 for both products. The total GDP is 200. Now assume that social distancing affects Sector 2 but not Sector 1. Only one worker can work in Sector 2. ( The Second worker lives far away and cannot take public transport.) Then we see that Sector 1 still produces 100 units but Sector 2 suffers 90% fall in output. Total GDP is 110 a drop of 45%. Unemployment is 25% as one worker is unemployed out of four. We can furlough the unemployed worker but output cannot be restored.

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