As the Covid-19 pandemic is disrupting economies across the globe, policymakers are in search for suitable stabilisation policy measures. The scope and design of effective policy hinges on the channels through which the pandemic affects economic activity, in particular on the relative importance of the forces working on supply and demand (e.g. Baldwin 2020, Hassler et al. 2020). On the one hand, policymakers need to consider measures that shield productive capacity going forward. These policies are meant to weather disruptions for non-economic reasons in the supply of goods and services such as broken international supply chains or reductions in labour efficiency due to Covid-19 containment measures. On the other hand, policymakers need to consider demand stimulus measures to address potential demand deficiencies. Demand deficiencies can arise from actual and expected income risk and higher economic uncertainty. They can also materialise as a consequence of supply-side disruptions (Guerrieri et al. 2020), input-output propagation (Baqaee and Farhi 2020), or health risks (Eichenbaum et al. 2020). Policies to buffer demand deficiencies encompass direct or indirect transfers to specific consumers, tax cuts, or social security enhancement.
In this column, we discuss empirical evidence on the relative importance of supply and demand forces during the Covid-19 crisis in Germany based on a recent article (Balleer et al. 2020). We build on the basic economic prediction that prices reflect shifts in demand and supply. Given demand, a reduction in the supply of goods and services generates inflation. Holding production constant, deficient demand leads to disinflation. These fundamental predictions about inflationary supply shocks and deflationary demand shocks emerge, for example, from a disaggregated New Keynesian economy (Baqaee and Farhi 2020). We study planned price changes of German firms and find that forces working on supply and demand coexist, but demand deficiencies dominate in the early phase of the Covid-19 crisis.
Firm-level evidence on Covid-19 impact, supply and demand shifts
We exploit unique firm-level data from the ifo-Business Climate Survey (ifo-BCS), a monthly survey in all relevant sectors of the German economy. The survey combines detailed information about firm characteristics with realised and planned price-setting decisions of firms. Since April 2020, the survey questionnaire asks firms to assess the impact of the Covid-19 pandemic on their current business situation on a scale from -3 to 3, where negative numbers mean negative effects and vice versa. Figure 1 shows that the majority of firms are adversely affected, while about 10% of firms are positively affected by the crisis. Services are hit harder than retail, followed by wholesale and manufacturing. Severely affected services include travel arrangement and reservation services, the hospitality sector, and entertainment industries. Supermarkets strongly benefit. The leather industry, beverage manufacturing, and machinery repair and installation are most adversely affected in manufacturing. Positively affected manufacturers produce food, rubber and plastic goods, or pharmaceuticals.
Furthermore, in existing and newly added survey questions, firms are asked to assess the role of several demand and supply shifters. For instance, these questions ask whether firms stopped production or (partly) closed, lack intermediate inputs, rely on imports, or experienced changes in order books. Figure 1 shows the share of firms that experience a decrease in orders and the share of firms facing supply chain disruptions in each impact group. This figure suggests that negatively affected firms experience both adverse demand and supply shifts. In the June survey questionnaire, firms were also asked to assess the severity of disruptions to foreign and domestic demand, liquidity problems, regulations related to health measures, storage or supply chain problems, or lack of personnel due to the pandemic. Relative to the average response of a given firm, adverse demand clearly dominates all other factors according to this measure.
Figure 1 Covid-19 impact and adverse supply and demand shifts
Covid-19 impact and price setting
Early into the crisis, the German producer price index decreased by 0.8% in March, by 1.9% in April, and by 2.2% in May 2020 year-on-year. To control for other determinants of price-setting behaviour and to isolate the impact of Covid-19, we use the monthly information from the ifo-BCS on three-month-ahead planned price changes. Planned price changes of firms in this survey are a strong predictor of quarter-on-quarter producer price inflation in the manufacturing and retail/wholesale industries. A challenge to this approach, and price measurement in general during the Covid-19 crisis, is that certain goods and services are temporarily not available or transferable, and the associated changes in expenditure patterns. The reduction in product variety certainly matters for welfare. Javarel and O’Conell (2020) estimate an 85 basis points increase in the cost-of-living for the UK. In the case of the German economy, Cavallo (2020) finds that official inflation figures are biased upward by only 0.09 percentage points relative to actual inflation, i.e. adjusted for changes in current expenditures patterns. The focus on planned price changes further alleviates, in our view, these concerns.
Figure 2 shows that firms differentially exposed to Covid-19 display very similar dynamics in planned price changes up to March 2020. In March 2020, most of the public health measures to contain the pandemic in Germany were implemented (e.g. nation-wide school closures on 13 March and a nation-wide curfew on 22 March). Relative to firms with no or only weak exposure to Covid-19, we estimate a substantial rise of up to ten percentage points in the probability of planned price decreases for firms with strong negative exposure, and a concurrent decline in the probability of planned price increases, net of other determinants of price-setting behaviour. Conversely, positively exposed firms display an approximately seven percentage point higher chance of planned price increases and are less likely to plan price decreases. Since the majority of firms report negative effects of Covid-19 on their business, the frequency of planned price decreases is predicted to increase up to about five percentage points. If anything, the frequency of planned price increases is predicted to decline. Price-setting patterns as in Figure 2 can be observed in every sector individually, but are strongest in retail/wholesale industries.
Figure 2 Effects of Covid-19 impact on planned price adjustments
Notes: This figure shows the time series of the frequency of planned price decreases (top) and price increases (bottom) for each Covid-19 impact category as of 2020:M04, net of controls and fixed effects. Red: Strong negative impact, orange: negative impact, black: no impact, green: positive impact. The frequency-weighted average of all lines in a given month equals the month’s sample average.
Deflationary demand and inflationary supply shifts?
Our findings suggest a dominant role for demand in price-setting behaviour early into the crisis. We further support this interpretation along two dimensions. First, we verify that firms that predominantly report adverse demand effects – based on the extra questions in the June survey questionnaire – have a higher probability of planning price decreases and a lower probability of planning price increases. The opposite is true for firms that predominantly report adverse supply effects.
Second, we explore the effects of supply and demand shifts within Covid-19 impact groups of a given industry. While such detailed heterogeneity analysis lacks sufficient statistical power to draw strong conclusions, we find that positive demand shifts increase the probability of planned price increases and negative demand shifts increase the probability of planned price decreases most of the time. For example, firms in retail/wholesale industries that are strongly negatively affected by the Covid-19 crisis and report a reduction in orders are up to 19 percentage points more likely to plan price decreases than comparably affected firms that do not experience a reduction in orders. Disruptions in supply, in turn, dampen the estimated average effect and increase the chance of planned price increases.
Interpretation and policy implications
Our evidence is consistent with inflationary supply and deflationary demand shifts in the Covid-19 recession and highlights the coexistence of both forces. Brinca et al. (2020) obtain similar results for labour supply and demand and in the US. Unlike these authors, we find that demand deficiencies dominate over supply-side forces on net and are particularly strong in adversely affected firms.
These findings are in line with a number of studies that highlight the importance of weak demand during the Covid-19 crisis. Differential demand deficiencies can arise through several channels. First, higher economic uncertainty might adversely affect the demand for durables relative to non-durables. Second, demand deficiencies are expected to be large in firms particularly exposed through their input-output structure (Baqaee and Farhi 2020). Third, demand deficiencies are larger for goods that are less substitutable (Guerrieri et al. 2020). Finally, Covid-19 may itself reduce the demand for certain goods for which consumption is associated with health risks (Eichenbaum et al. 2020).
Our findings therefore suggest a role for policy to stabilise aggregate demand. Monetary policy, constrained by the effective lower bound, seems an unlikely candidate. Moreover, even if there was policy room, a higher frequency of price change implies more aggregate price flexibility such that monetary stimulus would become less effective. Fiscal policy appears a more promising candidate. The German stimulus package announced on 6 June – including a temporary reduction in value-added taxes, transfers to families with children, and investment subsidies – is a step in that direction.
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