Effective Demand Failures and the Limits of Monetary Stabilization Policy
The challenge for stabilization policy presented by the COVID-19 pandemic stems above all from disruption of the circular flow of payments, resulting in a failure of what Keynes (1936) calls “effective demand.” As a consequence, economic activity in many sectors can be inefficiently low, 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 interest-rate reductions fail 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.
An earlier version was presented at the 2020 NBER Summer Institute under the title “Pandemic Shocks, Effective Demand, and Stabilization Policy.” I would like to thank Aloísio Araújo, Gauti Eggertsson, Guido Lorenzoni, Argia Sbordone, Ludwig Straub, Harald Uhlig, and Iván Werning for helpful comments, and Yeji Sung for research assistance. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.
Michael Woodford, 2022. "Effective Demand Failures and the Limits of Monetary Stabilization Policy," American Economic Review, vol 112(5), pages 1475-1521.