Ambrogio Cesa-Bianchi and Andrea Ferrero

Restrictions on activity to curb the spread of Covid-19 led to a shutdown of specific parts of the economy. These lockdown measures can be thought of as a shock that suddenly decreases the supply of affected sectors, which lowers output and increases their price. Guerrieri et al (2020) propose a theoretical model of ‘Keynesian supply shocks’ where a sectoral supply shock triggers knock-on effects on demand in other sectors which, if strong enough, can lead to a fall in aggregate prices and output – thus resembling an aggregate demand shock. In a recent paper, we provide empirical evidence supporting this hypothesis using pre-Covid data. Our results suggest a different way to look at the Covid crisis and business cycles in general.

What are Keynesian supply shocks anyway?

An example can help clarify the basic logic of Keynesian supply shocks and their transmission mechanism. Suppose the economy consists of two sectors, entertainment (offering movies in cinemas) and food (producing popcorn). A negative supply shock hits the entertainment sector so that the price of movie tickets increases. What happens to the food sector? If the two goods are substitute, people switch from going to the movies to eating popcorn at home. The demand for popcorn increases, and so does their price to clear the market. If the two goods are complements, however, people do not enjoy eating popcorn without watching movies. In this case, the demand for popcorn falls and so does their price. As a result, the overall effect on prices is likely to be ambiguous. This second case corresponds to a Keynesian supply shock.

New empirical evidence

In a recent paper, we offer empirical support to the notion of Keynesian supply shocks using data on gross output and prices for 64 sectors of the US economy from 2005 Q1 to 2019 Q4. Any approach that only relies on aggregate data would simply classify sectoral supply shocks with aggregate demand consequences as aggregate demand shocks. Yet, sectoral data per-se are not a silver bullet, as separating sectoral shocks that have aggregate consequences from true aggregate shocks poses severe identification challenges.

In our paper, we pursue a third route that does not require to explicitly separate aggregate shocks from sectoral shocks with aggregate consequences. The intuition for our approach is that while aggregate demand shocks and Keynesian supply shocks imply the same restrictions on the response of aggregate data – both giving rise to positive comovement between quantities and prices – the sectoral responses to these shocks are different. True aggregate demand shocks should move quantities and prices in the same direction in all sectors. Keynesian supply shocks should instead move quantities and prices in opposite directions for those sectors that are directly hit by the sectoral shocks.

We formalize this intuition by specifying a multi-sector VAR model where sectoral output growth and inflation load on a vector of unobserved common factors that capture the comovement across sectors. Three key steps underpin our empirical analysis. First, we proxy the common factors by means of cross-sectional averages of the sectoral data, ie, with aggregate output growth and inflation. Second, we employ a standard sign restriction approach to extract two structural shocks from the common factors, one that leads to positive comovement between quantities and prices and one that leads to negative comovement between quantities and prices. We label these innovations aggregate ‘demand-like’ and aggregate ‘supply-like’ shocks, respectively, as their effects might be the result of truly aggregate shocks as well as sector-specific shocks with aggregate effects. Third, and finally, we estimate the sectoral loadings on the identified aggregate demand-like shock, which are key objects of interest of our analysis. These objects capture the impact response of each sector’s quantities and prices to the aggregate demand-like shock.

What the paper finds

While sectoral output and prices typically comove in response to aggregate demand-like shocks – mimicking the behaviour of their aggregate counterparts – in about 40% of cases we find that the two variables move in opposite directions. Our interpretation is that standard shock identification techniques that impose restrictions on aggregate data only (as the ones we use to extract the structural shocks form the common factors) mis-classify shocks. In particular, some aggregate demand-like shocks are likely to be the consequence of a sectoral supply shock with strong complementarities at play – the Keynesian supply mechanism. Importantly, our sample ends in 2019 Q4 and thus the Covid episode does not drive the identification of the sectoral responses. Through the lenses of our analysis, the response to the pandemic has just been an extreme realization of a more general structural feature of the US economy.

As an example, the figure reports the distribution of the factor loadings for output growth (yellow) and inflation (blue) to a negative aggregate demand-like shock in two selected sectors. The left panel, which refers to the Accommodation sector, shows the example of a sector that responds to the demand shock in line with the restriction imposed at the aggregate level, ie, with prices and quantities moving in the same direction. However, in many sectors the response of output growth and inflation is inconsistent with such a notion of demand shocks. For example, in the Apparel and leather and allied products sector (right panel), a fall in output growth is accompanied by an increase in inflation. This pattern is a robust feature of the pre-Covid data across many sectors of the US economy, suggesting that Keynesian supply shocks may be a regular feature of business cycles.

Policy implications

The distinction between ‘true’ aggregate demand shock versus Keynesian supply shocks matters, even though both lead to a contraction in output and inflation. If Keynesian supply shocks are quantitatively relevant, monetary policy is less likely to face trade-offs between output and inflation. As a corollary, policymakers can respond more aggressively to shocks, even when uncertain about their nature. In the first stages of the pandemic, substantial disagreement around the future evolution of inflation emerged, as the economic effects of the Covid-19 outbreak and the policy response combined supply and demand aspects. According to our empirical findings, the balance of risks would have been more skewed towards a fall in inflation than a standard aggregate supply/demand framework would have implied, thus justifying an aggressive monetary policy easing.

More generally, our findings suggest that breaking the dichotomy between aggregate demand and supply disturbances may be a fruitful avenue to advance our understanding of the sources of business-cycle fluctuations and, crucially, to design the appropriate policy responses.


Ambrogio Cesa-Bianchi works in the Bank’s Global Analysis Division and Andrea Ferrero works at the University of Oxford.

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Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.



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