Unit 3 Aggregate demand and the multiplier model
3.13 Application: China’s post-COVID-19 aggregate demand problem
When China suddenly dropped its zero-COVID policy in late 2022, many observers expected a rapid bounce-back in economic activity. Having been locked down so tightly for so long, wouldn’t Chinese households respond to the policy change with strong consumption spending as had been observed elsewhere? This did not happen.
Interpreting data for China is different from the high-income countries—China’s growth rate is much higher and it was expected to grow by 5% per annum following the lifting of the zero-COVID policy. Nevertheless, there were signs of seriously weak aggregate demand. In particular, youth unemployment was 20% and weak consumer confidence so worried the authorities that they ceased publishing the data. The models in this unit help explain China’s post-COVID aggregate demand problem.
In the high-income countries, governments provided generous income support to workers who were unable to work because of government-mandated stay-at-home orders and their knock-on effects throughout the economy. Think, for example, of the multiplier process operating through a central business district due to the sudden absence of office workers.
The data for the US in Figure 3.25 shows that GDP dropped dramatically in the second quarter of 2020 (by 30% compared with the previous quarter, reported at an annual rate) with most of the effect coming from consumption. It rebounded in the following quarter because of the generosity of unemployment benefits (note that those transfers show up in ‘C’ and not ‘G’ in aggregate demand and in the table).
Quarter | GDP (QoQ) | C | I | G | X – M |
---|---|---|---|---|---|
2019 Q4 | 1.80 | 1.55 | –1.48 | 0.41 | 1.30 |
2020 Q1 | –4.60 | –4.25 | –0.88 | 0.57 | –0.05 |
2020 Q2 | –29.90 | –23.00 | –9.65 | 1.57 | 1.30 |
2020 Q3 | 35.30 | 26.30 | 12.70 | –0.97 | –2.74 |
2020 Q4 | 3.90 | 2.53 | 3.07 | –0.01 | –1.68 |
2021 Q1 | 6.30 | 7.00 | –0.80 | 1.18 | –1.02 |
Figure 3.25 Contributions to the change in US GDP, COVID-19 episode.
FRED, Table 1.1.2, Contributions to Percentage Change in Real GDP, Quarterly. In this table, ‘G’ includes government investment spending.
Note: QoQ refers to ‘quarter on quarter’ (the change between one quarter and the previous quarter).
China does not have a co-insurance scheme (Section 3.10) like the ones in high-income countries, which provided unemployment benefits or furlough payments that replaced a large proportion of an employee’s wage in the pandemic. The result was that when China’s zero-COVID policy resulted in lockdowns, households had to draw down their accumulated savings. Chinese households relied on self-insurance. Having experienced severe job insecurity for two years and run down their savings, many Chinese households were very cautious when the restrictions were lifted. The priority was to rebuild their buffer of savings rather than to go on a consumption splurge.
Reports of very high investment in electric vehicles and other parts of the renewables supply chain in China obscure the weak investment elsewhere. This is partly the consequence of US export controls affecting semiconductors, which, in line with the model, created great uncertainty and delayed investment spending.
When weak aggregate demand had threatened the Chinese macroeconomy before COVID, the response was higher government investment spending on infrastructure and housing. However, neither was viewed as a solution to the post-COVID aggregate demand deficit.
Exercise 3.10 COVID-19 savings behaviour and the multiplier model
The pandemic was a large negative shock to aggregate demand. Use the multiplier model to answer the following questions.
- Show the effect of the pandemic shock on output. Assume the economy was in equilibrium before the pandemic.
- In a new diagram, model the effect of a rundown of household savings, as was the case in China. Explain, with an income/consumption path diagram, how this rundown provides consumption smoothing and its effect on output.
- In a new diagram, assume the pandemic shock is over. Show the effect of households rebuilding their savings. Compare the new equilibrium with the initial equilibrium before the pandemic.