The effects of supply and demand shocks on contraction in production are equally strong
The COVID-19 pandemic can be seen as both a supply shock and a demand shock. On the one hand, on the supply side, workplaces are closed in order to prevent the spread of the virus, which partly halts production. These supply effects can be amplified if (cross-border) supply chains are disrupted. On the other hand, on the demand side, households are less likely to leave their homes, for example because of containment measures or the fear of becoming infected, which reduces consumption. An increase in unemployment and a fall in income could further exacerbate these demand effects.
For stabilisation policy to be effective, it is important to take into account the relative magnitude of supply effects compared to demand effects. After all, a major downturn on the supply side requires a different policy response than a strong drop in demand. The relative importance of supply and demand shocks is also relevant for monetary policy, as inflation usually responds differently to a supply shock than to a demand shock.
Compared to the first three months of this year, the second quarter showed a sharp contraction in Dutch production due to the pandemic and the corresponding containment measures. The pandemic has also led to a significant decline in economic activity in most business sectors. In Figure 1, production growth in the second quarter is broken down into the part that can be explained by either supply shocks or demand shocks, both at national level (top row) and sectoral level. Supply and demand shocks are identified on the basis of conventional economic theory: a positive supply shock is a shock that leads to an increase in production and a decrease in prices, while a positive demand shock increases both production and prices. By imposing these restrictions, the supply and demand shocks can be estimated using an econometric model. Figure 1 shows that the economic contraction in April to June is roughly equally accounted for by negative supply and demand shocks. The hardest affected sectors are Culture, Sports & Leisure, Trade, Transport, Storage & the Catering Industry, and Business Services. This follows from the fact that containment measures mainly concerned the services sector and because the Netherlands is an open economy in which international trade plays a major role. The Information & Communications sector showed a small positive demand shock, which may have to do with an increase in demand for telework-related services.
Figure 1 - Contribution of supply and demand shocks to production growth (2020 Q2)