Macroeconomics of Pandemics

For many decades preceding the Great Depression, the economic theory was rooted in the production and supply analysis. Say’s law in a simplified form suggested “Supply creates its own Demand”. Implied was firms would produce goods and they would have their takers. If there was excess supply relative to demand, the price mechanism would come into effect creating a drop in prices. The drop in prices thus would increase the quantity demanded while at the same time reducing the quantity supplied thus restoring the equilibrium. The notion of equilibrium was dispelled in the Great Depression when low prices did not create the corresponding increase in demand.

The answer to the puzzle was first articulated by John Keynes who argued there is deficiency of demand and thus the government had to play a role in fulfilling the lack of demand. In other words, Keynes suggested that demand creates supply. The Keynesian formulation laid the foundations of macroeconomics and with it the framework for Aggregate Demand and Aggregate Supply.

The macroeconomic growth is linked to the relationship between firms and households. Firms produce goods and services which are consumer by the households. The firms need factors to produce goods and services which are provided by households in exchange for factor payments. These factor payments are the source of income for households and used to consume goods and services thus creating a circular flow. Of course, households do not merely consume all their income but also save. The savings channelized through the financial intermediaries get injected back into the system as investment used for asset creation in the economy. Besides, the households pay taxes to the government which is injected back as government consumption expenditure.

The market value of all final goods and services produced in an economy in a given period of time is the measure of Aggregate Supply (AS). The expenditure of the households through consumption, savings routed back as investment, government expenditure arising through payment of taxes and the transactions of firms and households with the external sector through a measure of Net Exports (Exports – Imports) result in the Aggregate Demand (AD). The macroeconomic equilibrium is the outcome of balancing the AS with AD.

Imbalances between AD and AS are sought to be resolved through the application of fiscal and monetary policy. While the monetary policy through changes in interest or changes in money supply seeks to alter the variables either on supply side or demand side, the fiscal space is ensured through two means. Firstly, the government can intervene directly through an increase or decrease in government expenditure or through indirect means as increase or decrease in tax rates implying changes in consumption or investment. The imbalances either arise out of AS shocks or AD shocks. AS shocks arise of industrial contraction, wars disrupting production, natural disasters etc. The AD shocks arise out of sudden drop in consumption or investment for various reasons. While the analysis throughout was revolving around the existing prospective causes of shocks, very little arises out of shocks created by pandemics. The Wuhan virus originating in Hubei China brings a new challenge to macroeconomists. It would be interesting to see the necessary solutions to the possible crisis arising in economies worldwide.

There is AS and AD yet what is happening is the inability of the two to meet. There is production and distribution, the buyers are willing to buy yet the fear of contact and thus possibility of contracting the Wuhan virus is making people reluctant to buy and producers reluctant to open to sell. It is a little different situation thus in contrast to the existing theoretical assumptions. Assuming stores want to remain and so do eateries but people might not want to use the same. Alternatively, the government through order prevents the people from using the services or alternatively ask the producers not to offer their goods at the final mile delivery end. Thus it can be an induced AD shock or induced AS shock. In fact, rather than induced AD or AS shock, it is rather prevention of meeting between AD and AS. This disruption in interaction between AS and AD though both might be available in sufficient numbers in the long run will impact AS side of the equation.

Yet this disruption in the chain of interaction between AD and AS will not remain one off. It is a continuous function and not discrete. The continuous function results in the decline in AS since the inventory levels will rise or there would be perishable inventories that would get destructed. The lower incomes thus earned by firms will result in displacement and retrenchment of labour. The labour losing the sources of income would curtail their consumption causing the decline in Aggregate Demand. Further, the decline in firm income would imply inability to repay interest and principal thus savings would get held up impacting the banks. The lower factor income from interest will create a further vicious cycle of declining AD.

This cycle of disruptive AS and AD through a certain finite period would pose new puzzles to economists as they seek to resolve these macroeconomic uncertainties. Once the pandemic is eradicated, the growth will pick up and see faster growth and perhaps aid in economic recovery, a reminiscent of the post war period but the human endeavour to last the uncertain war with no clear end in sight might yield to unintended consequences. The Finance Minister in her package will have to factor in the same and thus one might see the birth of Universal Basic Income in some form or the other.