CARES ACT Impact on the American Economy
Katherine Ashley Chen
April 10, 2022
COVID-19 Effects on American Economy
At the end of 2019, word began to spread about a novel coronavirus: “lethal, infectious, risky”, journalists reported. Less than a month later, the newly named COVID-19 had spread to the UK, and later the US. In another month, the WHO declared a pandemic, upending society into chaotic disarray.
As the fear of COVID-19 spread throughout the US, Americans anticipated a potential supply shock and began stockpiling items such as masks, detergent, and personal hygiene equipment. Aggregate demand increased, resulting in a higher equilibrium price level and higher real GDP.
Later, as the pandemic escalated, local communities implemented more serious societal restrictions and countless workers were laid off, losing income streams and individual wealth. US unemployment reached a high of 14.8% after the first wave of COVID, the highest observable rate since 1948 (Congressional Research Service). Due to both pandemic restrictions and the wealth effect, consumption decreased significantly, decreasing the aggregate demand and resulting in a lower equilibrium PL and rGDP seen in figure 1 (Kashiwagi, Mankiw). A decreased investment spending due to lower revenues (decreased consumption) could also have been a contributing factor to the curve's further shift to the left (Portes). However, short run aggregate supply also decreased due to decreased productivity and increased commodity prices (Kashiwagi), leaving a further decreased output along with a higher prices in the cost-push inflation (Reading). All in all, there was a recessionary gap, and with that, increased unemployment, mainly due to three reasons:
First, excessive COVID-19 regulations and hygienic procedures resulted in the impossibility of certain jobs, and a reduced capacity for other jobs, especially in industries such as service and hospitality, causing a large percentage of layoffs (Shambaugh).
Second, fewer incentives to go out and spend money led to lower revenues for business, who in turn were unable to hire as many workers or spend as much on equipment due to a lower capacity to invest (Shambaugh).
Third, less human contact along with heightened hospitalization encouraged strategic consumer spending, where people were less likely to spend on luxury goods or high-ticket items, and instead spend on necessities, again resulting in less revenue and capacity to invest for businesses, contributing to a higher unemployment rate (Jones).
It is important to bear in mind a key limitation of the aggregate price level measurement: Although theoretically there was an increase in the aggregate price level, it is almost impossible to compared pre-covid consumption to ongoing covid consumption, due to large changes in expenditure share of consumption at the onset of the pandemic and throughout, as seen in Figure 2 (Barua).
In correspondence to the decrease in AD, there was rightward movement down along the Phillips SRPC curve, decreasing inflation rate and increasing unemployment, which is consistent with previous discussion of decrease in economic activity and increase in unemployment. Additionally, to match the decrease in SRAS, SRPC also increased, increasing unemployment further past the original natural rate of unemployment. The increase in LRPC also corresponded to the temporary decrease in LRAS. However since the economy was in stagflation, the Phillips curve was severely limited due to people’s expectations of inflation (Greenlaw). In other words, although there may be a tradeoff between inflation and unemployment when people expect no inflation, when inflation is occurring, that tradeoff disappears (Greenlaw).
As COVID infection rates soared, the vicious cycle of reduced capacity, increased unemployment, and reduced investment meant that the government had to step in.
Policy: CARES ACT
To combat lower household incomes along with higher price levels, Congress passed numerous pieces of legislation, including the Coronavirus Preparedness and Response Supplemental Appropriations Act, the Families First Coronavirus Response Act, and most importantly, the CARES Act, an economic stimulus bill totalling in $2 trillion USD that included $293 bil USD in direct payments to Americans, $510 billion in loans to major industries, and $377 billion in small business administration loans (“A Breakdown of the Cares Act”, “What’s in the $2 Trillion Coronavirus Relief Package?”).
By increasing the money supply, the Fed decreased the nominal interest rate, which increased the demand for money. Additionally, by increasing the real wealth of its citizens through providing personal governmental benefits and individual stimulus checks, aggregate demand increased, resulting in a higher real GDP output, closer to the original equilibrium output. According to PWBM, the CARES Act will increase GDP by $812 billion over the next two years (Paulson). Moreover, in increasing the AD, aggregate price level also increased.
Real world data from low-income households shows that stimulus checks did not just increase the consumption component of AD in theory, it actually altered it in reality by giving Americans more money to spend on both necessities and non-necessities (Li et al.).
Additionally, the loans and subsidies that the government provided to businesses absorbed the increased business costs, which effectively decreased the input costs of SRAS and increased SRAS. Because of the double shift, only the increased output can be concluded, while the aggregate PL remains indeterminate, but likely higher due to the governmental policy’s heavier emphasis on the AD side of the economy.
The government policy’s increase in AD also resulted in upward movement along the Phillips SRPC2 curve, while the increase of SRAS correlated with a subsequent decrease of the SRPC. The resulting decrease in equilibrium unemployment rate and increase in inflation is a positive thing for the economy, and aligns with the PWBM of an increase in 1.5 million jobs by the CARES Act (Paulson). However, the shift was not enough to return inflation and unemployment rate to pre pandemic levels.
As part of the CARES Act, the Fed attempted to incentivize investment spending by increasing the money supply via repo open market operations, lowering the federal funds rate by 1.5 percentage points, temporarily relaxing regulatory requirements (eg. decreasing the reserve requirement), and decreasing the discount rate, in addition to the increased subsidy, bailouts, and loans as previously mentioned (Milstein and Wessel). US interest rates were cut to 0%, lower than ever before (“Federal Deficits, Growing Debt, and the Economy in the Wake of COVID-19”).
Loanable Funds Market
In doing so, the government inadvertently increased the budget deficit to 3.7 billion, 18% of its GDP (Mankiw). This increased the demand for loanable funds, resulting in an increase in the quantity of loanable funds as well as the real interest rate (Goy and Willem van de End). Due to the massive increase in the real interest rate due to the government's $2 trillion USD relief package, the government unwittingly counteracted some of the encouragement of investment spending through the process of “crowding out” (Marcussen, Wade).
MPC and GDP Impact
Additionally, the prolonged existence of COVID fundamentally altered American consumer culture. With a climate of heightened risk, Americans were more likely to save, decreasing the MPC and therefore making transfer payments less effective and lowering the impact that government policy had on increasing AD and correcting the economy faster in the short run. For example, MPC in the US was .4 on average in 2019, but dropped to .35 in 2020, at the beginning of COVID (“U.S. MPC: After Job Loss by Era 2020). As such, the increase in spending throughout the economy, as calculated by multiplying the transfer multiplier (MPC/1-MPC), would be: ($293bil* (.35/1-.35))= ($500bil *(.35/.65))= $162 bil increase in GDP. However, using the previous MPC, ($293 bil*(.4/.6)) =$195 bil maximum increase in GDP.
Money Multiplier and Money Supply Increase
Moreover, due to the ripple effect of the fractional banking system, and the system’s ability to “create” money, the money supply increase was far greater than the money the government spent on stimulus checks. To simplify our calculation, we use a reserve requirement of 10%, which was the average reserve requirement during this time period. Thus, purely from the basis of stimulus spending, and opting for an optimistic outlook in assuming that half of the $293 mil USD In the first CARES Act stimulus package was deposited into the banking system, we can calculate the maximum change in the money supply. MM=1/RR, therefore MM=10.
= $1.465 trillion USD maximum change in the money supply.
Of course, with these parameters, a $1.465 trillion increase in the money supply is the maximum potential increase, and is likely far too optimistic due to people’s increased likelihood of storing money as cash due to the low interest rates. Banks also may have chosen not to loan out all their excess reserves, as modern banks tend to lean on the conservative side after the financial fiasco of 2008. These limitations contribute to the hindrance of the governmental policy’s full potential impact on the economy, and show that while the government policy has been relatively effective in certain areas, it hasn’t been able to restore the economy back to pre-pandemic conditions.
While the policies have been partially effective in moving AD, SRAS and LRAS towards pre-pandemic levels, it has been difficult to combat unemployment due to 1) large unemployment benefits discourage workers from looking for jobs, and 2) shutting down of businesses due to coronavirus restrictions naturally decreases number of job opportunities (Shambaugh). It is important to note that COVID economic contraction is unlike other economic crises, as governments have intentionally restricted economic activity to prevent the spread of the virus. With businesses shutting down, economic activity will contract no matter what policy the Fed attempts to implement(Shambaugh). Additionally, while the Fed can make it easier to borrow, uncertainty about the outcomes of the pandemic make it difficult to borrow regardless of the conditions(Shambaugh). The immediate economic fiscal policy, including the CARES Act, then, merely aims to cushion the downward shock in the economy, and not completely reverse the contraction from COVID-19 (Shambaugh).
In conclusion, although government policies have been partially effective in increasing aggregate demand and short run aggregate supply to increase output, the policies cannot possibly be adequate enough to reverse the economic shock caused by COVID. Policies have not been nearly as effective in lowering price levels back to pre pandemic conditions, leaving American consumers with higher bills to pay. Additionally, governmental policy to incentivize investment spending has been largely impeded by large government deficits crowding out business investors in the loanable funds market, leaving that part of the policy rather ineffective. However, it is important to keep in mind that the COVID-engendered contraction in the economy is unlike any economic crisis the US has experienced, due to the intentional decrease in activities of citizens. Thus, while the activities of the Fed are important, they are unlikely to ever be completely sufficient given the constraints of the situation.
Albuquerque, Bruno, and Georgina Green. “Bank of England Staff Working Paper No. 965.” Bank of England, Bank of England UK, Mar. 2022, https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2022/financial-concerns-and-the-marginal-propensity-to-consume-in-covid-times.pdf?la=en&hash=F7D259700620FC1560A3A0C62CBE3B0A9A091419.
Barua, Akrur, et al. “Consumer Spending Forecasts: Services Find Their Way Back after a Forgettable 2020.” Deloitte Insights, Deloitte, 27 Oct. 2021, https://www2.deloitte.com/us/en/insights/economy/spotlight/consumer-spending-forecast-2021.html.
Bofinger, Peter, and Mathias Ries. “Excess Saving and Low Interest Rates: Theory and Evidence.” VOXEu, Center for Economic and Policy Research, 29 July 2017, https://voxeu.org/article/excess-saving-and-low-interest-rates-theory-and-evidence.
“A Breakdown of the CARES Act.” J.P. Morgan, JPMorgan Chase &Co., 14 Apr. 2020, https://www.jpmorgan.com/insights/research/cares-act.
Chowdhury, Aftab. “How Has Inflation Behaved during the Pandemic?” Economics Observatory, Economic and Social Research Council, 11 Nov. 2021, https://www.economicsobservatory.com/how-has-inflation-behaved-during-the-pandemic#:~:text=From%20Figure%203%2C%20we%20have,stringent%20lockdown%20measures%20were%20relaxed.
“Federal Deficits, Growing Debt, and the Economy in the Wake of COVID-19.” Congressional Research Service, Congressional Research Service, 23 Mar. 2021, https://sgp.fas.org/crs/misc/R46729.pdf.
Goy, Gavin, and Jan Willem van de End. “The Impact of the COVID-19 Crisis on the Equilibrium Interest Rate.” VOXEu, Center for Economic and Policy Research, 20 Apr. 2020, https://voxeu.org/article/impact-covid-19-crisis-equilibrium-interest-rate.
Greenlaw, Steven A. “25.3 The Phillips Curve.” The Principles of Economics, OpenStax Economics, edited by Timothy Taylor, OpenStax CNX, http://firstname.lastname@example.org. Accessed 19 Mar. 2022.
Jones, Katie. “How Has Coronavirus Changed Consumer Spending?” World Economic Forum, World Economic Forum, 2 May 2020, https://www.weforum.org/agenda/2020/05/coronavirus-covid19-consumers-shopping-goods-economics-industry.
Kashiwagi, Ryoji. “Putting the Economic Shock of the Coronavirus in Context.” NRI, Nomura Research Institute, May 2020, https://www.nri.com/en/knowledge/publication/fis/lakyara/lst/2020/-/media/98FEC3C2A2C14BDE8764A3749D9EC987.ashx.
Krager, Ezra, and Aastha Rajan. “Heterogeneity in the Marginal Propensity to Consume: Evidence from Covid-19 Stimulus Payments .” Federal Reserve Bank of Chicago, Federal Reserve Bank of Chicago, May 2020, https://www.chicagofed.org/publications/working-papers/2020/2020-15.
Li, Kangli, et al. “Impacts of Covid-19 Lockdowns and Stimulus Payments on Low-Income Population's Spending in the United States.” PLOS ONE, Public Library of Science, 8 Sept. 2021, https://journals.plos.org/plosone/article?id=10.1371%2Fjournal.pone.0256407.
Mankiw, Gregory. “The COVID-19 Recession of 2020 .” Harvard College, The President and Fellows of Harvard College, Aug. 2020, https://scholar.harvard.edu/files/mankiw/files/covid-19_recession_of_2020_aug2020.pdf.
Marcussen, Michala. “The 'Crowding out' Risk to the Economy.” Financial Times, The Financial Times Ltd., 7 May 2021, https://www.ft.com/content/0789daa6-db4e-4523-91a6-c9f4f1d9dbb1.
Milstein, Eric, and David Wessel. “What Did the Fed Do in Response to the COVID-19 Crisis?” Brookings, The Brookings Institution, 9 Mar. 2022, https://www.brookings.edu/research/fed-response-to-covid19/.
Paulson, Mariko. “Short-Run Economic Effects of the Cares Act.” Penn Wharton Budget Model, Penn Wharton University of Pennsylvania, 12 Oct. 2020, https://budgetmodel.wharton.upenn.edu/issues/2020/4/8/short-run-effects-of-the-cares-act.
Portes, Jonathan. “The Lasting Scars of the COVID-19 Crisis.” VOXEu, Center for Economic and Policy Research, 1 June 2020, https://voxeu.org/article/lasting-scars-covid-19-crisis.
Reading, Brian. “Return of Cost-Push Inflation May Lead to Stagflation.” OMFIF, Official Monetary and Financial Institutions Forum, 18 Oct. 2021, https://www.omfif.org/2021/10/return-of-cost-push-inflation-may-lead-to-stagflation/.
Shambaugh, Jay. “Covid-19 and the US Economy: FAQ on the Economic Impact & Policy Response.” Brookings, Brookings, 9 Mar. 2022, https://www.brookings.edu/blog/up-front/2020/03/23/covid-19-and-the-u-s-economy-faq-on-the-economic-impact-policy-response/.
“U.S. MPC: After Job Loss by Era 2020.” Statista, Statista, 18 Oct. 2021, https://www.statista.com/statistics/1269519/us-mpc-after-job-loss-era/.
“Unemployment Rates during the COVID-19 Pandemic .” Congressional Research Service, Library of Congress, 20 Aug. 2021, https://sgp.fas.org/crs/misc/R46554.pdf.
Wade, Keith. “Does the Surge in Government Borrowing Matter?” Schroders, Schroder Investment Management, 9 Aug. 2020, https://www.schroders.com/en/hk/institutional-service/insights/managers-views/does-the-surge-in-government-borrowing-matter/.
“What's in the $2 Trillion Coronavirus Relief Package?” Committee for a Responsible Federal Budget, Committee for a Responsible Federal Budget, 25 Mar. 2020, https://www.crfb.org/blogs/whats-2-trillion-coronavirus-relief-package.
Image 1 Credit to New Jersey State Library