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Effective Demand Failures and the Limits of Monetary Stabilization Policy

Michael Woodford ()

No 15211, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: The COVID-19 pandemic presents a challenge for stabilization policy that is different from those resulting from either "supply" or "demand" shocks that similarly affect all sectors of the economy, owing to the degree to which the necessity of temporarily suspending some (but not all) economic activities disrupts the circular flow of payments, resulting in a failure of what Keynes (1936) calls "effective demand." In such a situation, economic activity in many sectors of the economy can be much lower than would maximize welfare (even taking into account the public health constraint), and interest-rate policy cannot eliminate the distortions --- not because of a limit on the extent to which interest rates can be reduced, but because monetary stimulus fails to stimulate demand of the right sorts. Fiscal transfers are instead well-suited to addressing the fundamental problem, and can under certain circumstances achieve a first-best allocation of resources without any need for a monetary policy response.

Keywords: circular flow; Covid-19 pandemic; Fiscal Transfers; Network structure (search for similar items in EconPapers)
JEL-codes: E12 E52 E63 (search for similar items in EconPapers)
Date: 2020-08
New Economics Papers: this item is included in nep-mac, nep-mon and nep-pke
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