Coronavirus has a particular effect, rarely seen on the economy. It can affect both demand and supply at the same time and, as far as we know, it can cause a rapid and mild economic downturn, as well as a tougher crisis. Furthermore, depending on the strongest effects, it requires completely different economic policy actions.
DROP IN SUPPLY
The economic effects of coronavirus are not primarily due to the direct health consequences of the disease, but to the measures taken to prevent its spread. In order to avoid dissemination, provisions have been made to limit the movement and contact of people. Travel bans, quarantines led to factory closings, service outages, supply difficulties, and disruption of the global value chain. This is called supply shock. The performance of the economy (Y) decreases because the production process is hindered. These types of shocks can in themselves lead to higher prices (P), as unchanged demand will come with lower and / or higher cost levels.
In the event of a supply shock, economic policy does not have simple tools. It can withdraw the measures that limit production, but the cost would be much more sick and deadly. It is possible to increase the effort to cure the disease, find a cure as soon as possible, or search for more effective and less restrictive production methods.
However, there is important positive news about the primary supply shock: after the epidemic has subsided, the effect quickly disappears and production returns. In addition, if the demand is not damaged, part of the lost production will be replaced. Especially in industrial sectors, this supply adjustment can be typical.
DROP IN DEMAND
The coronavirus epidemic not only erodes production conditions, but also reduces demand. Interest in tourism, hospitality, event organization or transportation services is decreasing due to people’s caution. This results in a decline in economic activity (Y) and a drop in prices (P).
A slightly more indirect effect, but for reasons of simplicity, we classify the primary demand shock as a drop in demand in the raw materials markets and in the transport sector following the drop in production. The most obvious sign of this is the rapid drop in oil prices. (Note in parentheses that we can see a positive effect of demand over the days, the buzz around the purchase of durable food.)
In this case, economic policy is less instrumental: it can try to replace demand with fiscal and monetary policy instruments. The budget can react with additional spending and tax cuts and monetary policy can lower interest rates. In the event of a demand shock, central banks need to fear less that their loose policies will lead to inflation. This is an important difference from the supply shock which leads to higher prices.
The coronavirus epidemic causes shock to supply and demand at the same time. Furthermore, it is not known for sure what caused it. For example, is a flight to Milan impossible because there is not enough demand for it, or would it be there but was canceled due to epidemic control?
The question is also interesting from the point of view of Hungarian monetary policy. Based on the inflation picture, we can say that the MNB has recently pursued an unduly loose monetary policy. However, if the demand shock for the coronavirus epidemic is severe, the central bank may think that monetary policy should not be corrected, as prices have a new cooling effect. However, if you underestimate the importance of falling demand and supply, you can easily measure optimal monetary policy.
Ideally, the world economy is overcoming the epidemic with a slight first impact effect from supply and demand shocks. However, if the outbreak is prolonged, further unfavorable processes may begin. Prolonged uncertainty and deteriorating business confidence can reduce demand for consumption and investment, leading to a further, wider decline in economic performance. Production stoppages, weak economic activity are destroying the stability of corporate finance, productivity growth has stalled and loss of revenue can cause debt-inducing businesses to go bankrupt.
Obviously, economic policy can attempt to address second-level effects with instruments similar to the previous ones: supply-side constraints through political measures and demand shocks through macroeconomic political instruments.
The nature and size of the shocks will be determined by the evolution of the coronavirus epidemic. For the moment, there is the possibility of a lighter exit, a rapid and short-lasting shock.