Policy responses to COVID-19
The short-, medium-, and long-term impact of the pandemic in Germany and the policy options to deal with
1. Introduction
In this article, I advise the new Minister for the Economy of Germany on the short-, medium-, and long-term impact of the Covid-19 pandemic and the policy options to deal with this economic impact. Frist, I will use the Keynesian model to analyse the short-term impact of the Covid-19 pandemic in Germany. Short-term is here defined as about half a year from the outbreak of the crisis. The model underlies the assumption that prices are constant. With this model I will illustrate the demand gap created by Covid-19. I will also discuss the impact of the sales tax cut as a classical instrument of expansionary fiscal policy.
Second, to analyse the medium-term impact of the Covid-19 crisis on the GDP and the price level in Germany, I will apply the AS-AD model. I define medium-term here as approximately one year from the outbreak. The model helps to explain the recession accompanied by a mild deflation in Germany. With the help of the AS-AD model, I will also conclude that the implemented Keynesian instruments such as expansionary monetary and fiscal policy of the German Government are appropriate to support the economy during the recession.
Third, I will analyse the long-term impact of the Covid-19 pandemic in Germany. I define long-term as more than one and a half year from the outbreak. By applying the AS-AD model, I will explain not only cyclical but also long-run growth effects, with shifts in the long-run supply (LRAS curve) based on the growth theory. According to the growth theory, I will project a moderately optimistic forecast based on the assumption that German economic policy uses the pandemic to support a structural change.
2. Impact of Covid-19 pandemic in Germany
2.1. Short-term impact and policy options
In the following, I explain the short-term impact of the Covid-19 crisis and the economic effects of the policy options of the German government aid packages. I applied the Keynesian cross model¹ to illustrate the impact and economic effects. The application of the model which assumes price rigidity is appropriate because no price increases are to be expected in the short term when companies’ production capacities are underutilized in the crisis.
2.1.1. Short-term impact in Keynesian cross model
The Covid-19 crisis impacted the economy in Germany twice, by a demand and a supply shock². First, the demand — specifically for export goods — decreased dramatically within a short period of time. Consequently, production cancellations resulted in a massive underutilization of existing production capacities. Second, there was a supply shock as supply chains were disrupted. Therefore, production was not possible anymore or at a lesser extent. In addition, due to the Covid-19 lockdown, services were ceased even completely in individual sectors such as hotels and restaurants.
To mitigate the double shock, the German government responded with liquidity assistance and subsidies as well as extensive credit-financed economic stimulus packages³ worth billions. As a result, the implemented policies mitigated the impact of the Covid-19, even though it did not prevent the decline in economic output. Consequently, Germany was less severely affected by the economic impact of the Covid-19 pandemic than other countries.
2.1.2. Stimulus package in Keynesian model
In the Keynesian model the sharp decrease in consumption, investment, and export goods demand as well as the lockdown which was caused by the Covid-19 shifted the effective goods demand function downwards (see Fig. 1). Under the assumption that Germany was at full employment before the Covid-19 pandemic, the crisis induces an underemployment equilibrium. The model shows that the difference between full employment and the full employment equilibrium indicates the underutilization of goods production.
The production function explains how the demand of companies for labour is linked. With an unchanged capital input, we can see that the less can be produced, the less labour is needed.
The Keynesian model was developed under the impression of the Great Recession in the 1930s. It assumes that people in a financial crisis respond by cutting their costs. Because an individuum cannot be expected to go into debt and consume more, the government has to compensate it. Therefore, Keynesian economic policy sees credit-financed government spending (deficit spending)⁵ as means to eliminate the underemployment equilibrium. The logic is that the debt which the government took on can be repaid in the economic upturn.
In Financial Crisis in 2008/09, extensive credit-financed government spending helped to mitigate the impact on the economy and the labour market based on the Keynesian model.
In the Covid-19 pandemic, Germany as well as other countries apply the Keynesian concept of deficit spending. To highlight is that Germany had a low debt ratio relative to the GDP in a global zero-interest rate environment because of its “black zero” policy. Germany induced a government’s stimulus package with two most important elements — temporary VAT cuts and family bonuses. Both policies caused an upward shift in the effective demand curve and helped to mitigate the COVID-induced decline in demand. In both cases the effect is based on an increase in net income.
First, when companies pass on the cost relief to consumers which happens in reality to some extent, the VAT increases the real net income 𝑌𝑟𝑒𝑎𝑙 𝑛. Consequently, the consumers are offered financial opportunities to consume more of the discounted goods and purchase other goods. In contrast, if consumers decide not to spend the savings, the demand stimulus could come to nothing. There would be no upward shift in the effective demand function. However, a voucher solution could have solved the problem.
Second, the family bonus directly increases the net income; even though this is only the case for low- and middle-income earners. For higher income earners in Germany, the disposable income does not change because the family bonus is offset against the child allowance. If low- and middle-income earners use a high share of the additional income to consume, it leads to an upward shift of the effective demand curve. This results in a reduction of the underemployment equilibrium.
2.2. Medium-term impact and policy options
In the following, I analysed the medium-term impact of the Covid-19 crisis⁶ in Germany by extending the short-term analysis from the previous chapter with the inclusion of price movements and adjustments in labour and capital markets.
2.2.1. Medium-term impact in the AS-AD model
2.2.2. Aggregate Demand (AD)
To analyse the medium-term impact, I applied the AS-AD model⁷ in which the country’s aggregate demand is modelled as a falling curve, assuming a variable price. A significant reduction in demand is called a demand shock.
The Covid-19 crisis led to a collapse of most of the components of aggregate demand in Germany (see Fig. 2). For example, private consumption decreased by 13 percent, gross investment fell by almost 9 percent, and exports and imports decreased significantly.
The sharp decrease in aggregate demand demonstrates the difficult economic policy trade-off of the crisis, not only a direct consequence of the medical crisis. In the long-run restrictive public health measures save lives. But in the short term they aggravate the recession that has already set in due to pessimistic expectations.
2.2.3. Aggregate Supply (AS)
In the AS-AD model, the aggregate supply curve is modelled with an upward slope because in the medium term it has an increasing trend. A supply shock can occur when supply conditions deteriorate sharply i.e., that a lower total output is produced in the economy.
At the beginning of the Covid-19 crisis, several administrative factors caused an abrupt deterioration in production conditions in Germany. At first, value chains in Europe collapsed due to a lack of intermediate products because of the closure of factories during the shutdown in China. Then the shutdown in most industrialized nations caused production to collapse due to large-scale factory closures.
Despite this severe short-term shock, the supply side recovered from some of these declines after a few months when manufacturing facilities reopened. The supply shock for Germany is displayed by the sharp drop in production index in the manufacturing sector which decreased to an all-time low at the beginning of 2020; and which remains far below its initial value after a recovery (see Fig. 3).
2.2.4. New equilibrium in the AS-AD model and possible shifts
To discuss the medium-term impact of the Covid-19 pandemic in Germany, I analysed the macroeconomic equilibrium in the AS-AD model (see Fig. 4). In this point all markets are in an equilibrium. At the beginning of 2020, the German economy was in a long-term equilibrium, with well-utilized production factors and a stable price level.
In the AS-AD model, the Covid-19-induced simultaneous decline in aggregate supply and aggregate demand leads to a new short-run equilibrium. The new equilibrium is characterized by a sharp decline in aggregate output, which is more severe than a one-sided supply or demand shock.
On the contrary, the shift of the price level is not predetermined. The reaction of the price depends on whether the supply or demand shock is larger. If the demand decreases more sharply, a deflationary phase might occur and vice versa.
A deflation seems to be currently the case in Germany. Even though significant price increases were observed in some sectors, these were mainly to compensate for the more difficult production conditions. In total, the price level increases in Germany declined during the Covid-19 pandemic and deflationary tendencies became even visible in the summer of 2020.
Empirical data provides evidence for the impact of the Covid-19 crisis outlined above in the AS-AD model in Germany. The GDP experienced the sharpest drop since the post-war period, specifically in Q2 2020. Additionally, the unemployment increased, but the increase was significantly slowed by various economic policy instruments. Nonetheless, a negative trend reversal was recorded after years of increasing improvement in the labour market situation (see Fig 5).
The Covid-19 crisis reversed the price level trend which was below the European Central Bank’s inflation target (ECB) of 2 percent. The inflation rate decreased significantly from March 2020 on and even turned negative (see Fig. 6).
The AS-AD model comprises the possibility of a medium-term adjustment, without government intervention. Because the new short-run equilibrium output is below the natural level of production, the price level is also lower than expected. This leads to a nominal wage decrease that shifts the AS curve to the right.
Whether this medium-term adjustment can be expected to occur in this way is questionable. Specifically, in highly regulated labour markets such as those in Europe a nominal wage reduction has been rather rare. But even in the absence of a nominal wage cut a price level reduction has been observed which may well have had demand-boosting effects. Despite that the decisive factor for a rightward shift in the supply curve is the removal of nonpharmaceutical interventions in the major industrialized countries.
2.2.5. Effect of monetary and fiscal policy
The expansionary monetary and fiscal policies¹³ can help to support aggregate demand and the economy to recover from the recession more quickly — in line with the Keynesian stimulus policies. In Germany, large fiscal and monetary policy measures were implemented in the first weeks of the Covid-19 crisis. In the following, I analysed the macroeconomic effects that can be expected in terms of model theory.
In the AS-AD model the aggregate demand is determined by the real money supply, government spending, and taxes. Expansionary fiscal policy measures increase government spending or reduce taxes; expansionary monetary policy aims at increasing the money supply. Both measures shift the AD curve to the right, creating a new short-run equilibrium with increased output and a rising price level (see Fig. 7). As some of the Covid-19 crisis output restrictions were relaxed again in the summer of 2020, the AS curve also shifted to the right, so that overall no particularly large effect on the price level were to be expected.
The medium-term adjustment predicted by the model in the case of expansionary economic policy is not to be expected. It would predict a rightward shift of the AS curve through rising price expectations, with prices rising again and output declining. Because the short-term Covid-19 equilibrium is an underemployment equilibrium, these expansionary measures help at best to approach the old equilibrium before Covid-19 which was close to the natural level of output in Germany.
2.3. Long-term impact and policy options
2.3.1. Long-term growth effects of Covid-19 pandemic
To analyse the long-term impact of the Covid-19 crisis, I used the growth theory¹⁴ which deals with the long-term development of the real GDP especially GDP per capita over several years. To assess the Covid-19 pandemic, I explained the growth-relevant effects by using the AS-AD model. For the long-term analysis, I used the AS curve of the model in the form of the vertical Long-Run Aggregate Supply curve (LRAS).
2.3.2. Long-term growth effects in growth theory
To analyse the implications of the Covid-19 crisis for long-term economic growth in Germany, I applied the economic growth theory by modelling a long-run shift of the LRAS curve in the AS-AD model (see Fig. 8). I assume that Germany was approximately in long-run growth equilibrium before the Covid-19 crisis. If we abstract from the short- to medium-term cyclical shifts in the curve, the LRAS curve shifts to the left, real GDP and therefore real GDP per capita become smaller.
Since the LRAS curve is vertical at the level determined by the production function, it can only shift if the quantities of production factors or the production technology change. It should be noted here that the reasons for a supply shock already mentioned act like a reduction in factor stocks. Particularly if employees are laid off or companies become insolvent, this can have a long-term impact on the effective availability of production factors. This is because both physical capital tied up in insolvent firms and human capital tied to the labour force can quickly depreciate. Such a shift in the LRAS curve is familiar from the oil crises of the 1970s/80s and has been described by the term “hysteresis”¹⁶ which can be translated roughly as “aftereffect”. For example, the skills of the unemployed decline with the duration of their unemployment. If these unemployed people no longer meet the requirements of the labour market and therefore do not make any further efforts to find a new job, they become part of the so-called natural rate of unemployment which is part of the natural level of real GDP. Consequently, the depreciation of human capital shifts the LRAS curve to the left.
As a result, the real GDP per capita is below the original natural level and as the pandemic resolves, for example due to the availability of vaccines, an adjustment growth occurs during which growth rates are higher than before the crisis. During this transition, though, the level of the real GDP per capita is lower than before.
In the absence of technical progress¹⁷, the new long-term equilibrium would return to the old level of per capita income, therefore that the decline in growth would only be temporary. More realistic, though, is that there is endogenous technical progress. In this case, a growth drop can theoretically never be recovered. This is because if in equilibrium the real GDP per capita increases steadily and this process is interrupted once, then the old growth rate can indeed be achieved again. But since, despite the temporary adjustment growth at higher rates, the growth process now starts at the old rate from a lower level in the new equilibrium, the difference remains forever.
This argumentation presupposes — as always in neoclassical growth theory — that the products which are produced are also demanded, because growth is analysed only on the basis of the development of the LRAS curve or the production function. In modern growth theory¹⁸, there are various approaches how endogenous technical progress arises. The most important are learning by doing i.e., an improvement in production technology based on experience, the accumulation of human capital through education, and the introduction of new products through R&D.
2.3.3. Effects of structural change
The technical progress in the endogenous growth theory¹⁹ results in different implications for future economic growth in Germany. Every economic crisis causes a temporary decline in production which impairs learning effects and consequently has a negative impact. The Covid-19 pandemic can, for example, have a negative impact on human capital accumulation²⁰ which also negatively affects economic growth. Despite the introduction of new products is seen in growth theory primarily in the context of efficiency gains in production or consumption, in the context of the dependence on demand one can also argue more broadly. This is because the Covid-19 pandemic can lead to insolvencies which tends to reduce product variety.
Though, economic policymakers have adopted stimulus programs to prevent insolvencies, which at €130 billion by far dwarf the programs in the aftermath of the Financial Crisis of 2008/09. For this purpose, it is crucial whether those industries are helped that can be expected to create products that are also in demand in the long term and consequently contribute to an effectively used rightward shift of the LRAS curve.
First for instance, the auto industry receives €2 billion as part of a bonus program for investments in innovations and new drive technologies. The existing purchase premium for electric cars will be increased, now worth €2.2 billion. From the point of view of the growth theory, this subsidy for new drive technologies can even be an opportunity because it accelerates the necessary structural change.
Second, the tax incentives for investment through improved depreciation options and the research allowances for 2020 and 2021 totalling €7 billion go in the same direction. Long-term growth requires investment in new capital goods, specifically in a country like Germany where the population and therefore the amount of labour tend to stagnate or even fall.
Third, public investments in infrastructure and future technologies some of which had already been decided anyway are being brought forward or extended. These measures are also to be welcomed from a growth theory perspective because they promote structural change.
3. Conclusion
In conclusion, I analysed the short-, medium-, and long-term impact of the Covid-19 pandemic and discussed the policy options in Germany by applying the in Keynesian cross model, AS-AD model, and growth theory. First in the short term, the Keynesian economic policy mitigated the massive economic downturn which was caused by the Covid-19 pandemic in Germany. The German government used deficit spending to counteract the economic decline in effective demand. Consequently, together with the short-time working scheme, the negative impact on the labour market was mitigated.
Second in the medium run, the Covid-19 crisis has had drastic macroeconomic effects. I applied the AS-AD model to represent the combined supply and demand shock that led to a new equilibrium with a sharp decline in GDP and rather falling prices. Whether there would have been an independent, medium-term adjustment even without government intervention like in theory is questionable. The large monetary and fiscal policy measures implemented are well suited to support the aggregate demand. Though the old equilibrium will naturally only be restored once public life has returned to normal.
Finally in the long term, many of the government stimulus programs are sensible and without government intervention the Covid-19 pandemic could not only have much more serious economic consequences in the short to medium term, but also cause a collapse in growth in the long term. The long-term GDP per capita will be smaller in real terms as a result of the pandemic, but with the current sensible economic policy that strengthens structural change in the direction of future technologies, there is still the prospect of positive development in the long term.
4. References
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[8] German Federal Statistical Office (2021a) Macroeconomic indicators, Retrieved from https://www.destatis.de/DE/Themen/Wirtschaft/Konjunkturindikatoren/Volkswirtschaftliche-Gesamtrechnungen/vgr111.html
[9] German Federal Statistical Office (2021b) Production index in manufacturing, Retrieved from https://www.destatis.de/DE/Themen/Branchen-Unternehmen/Industrie-Verarbeitendes-Gewerbe/_inhalt.html#sprg236488
[10] Sloman, J., Garratt, D. and Guest, J. (2018) Economics. 10th ed. London: Pearson (Parts E, F and G), p. 542
[11] German Federal Employment Agency (2020) Impact of the Corona Crisis on the Labor Market, September 2020, Nuremberg.
[12] German Federal Statistical Office (2021c) Price level development, Retrieved from https://www-genesis.destatis.de/genesis/online?operation=abruftabelleBearbeiten&levelindex=1&levelid=1625920880466&auswahloperation=abruftabelleAuspraegungAuswaehlen&auswahlverzeichnis=ordnungsstruktur&auswahlziel=werteabruf&code=61111-0002&auswahltext=&werteabruf=Werteabruf#abreadcrumb
[13] Sloman, J., Garratt, D. and Guest, J. (2018) Economics. 10th ed. London: Pearson (Parts E, F and G), p. 676ff
[14] Sloman, J., Garratt, D. and Guest, J. (2018) Economics. 10th ed. London: Pearson (Parts E, F and G), p. 713ff; Kitson, M. (2021) Seminar Macroeconomics, Lecture Unit 3/6, Cambridge: University of Cambridge, 3/6
[15] Sloman, J., Garratt, D. and Guest, J. (2018) Economics. 10th ed. London: Pearson (Parts E, F and G), p. 715
[16] Kitson, M. (2021) Seminar Macroeconomics, Lecture Unit 4/6, Cambridge: University of Cambridge, 4/6
[17] Sloman, J., Garratt, D. and Guest, J. (2018) Economics. 10th ed. London: Pearson (Parts E, F and G), p. 718ff
[18] Sloman, J., Garratt, D. and Guest, J. (2018) Economics. 10th ed. London: Pearson (Parts E, F and G), p. 729ff
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[20] Agarwal, P. (2020) “Economic Growth” Intelligent Economist, 18 April 2020
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