The Economic Ripple Effects of COVID-19

What are the effects of a temporary lockdown of the economy? Do firms' deteriorating balance sheets and labor market frictions propagate and prolong the effects? We answer these questions in a model with financial and labor market frictions. The model makes quantitative predictions about the effect of lockdowns of varying magnitude and duration on output, employment and firm dynamics. We find that the effects are not persistent if (i) workers on temporary layoff can be recalled by their previous employers without having to go through the frictional labor market and (ii) the government provides employment subsidies to firms during the lockdown. However, the effects are heterogeneous and young non-essential firms are disproportionately affected. In addition, if lockdowns lead to more permanent reallocation across industries, the recession becomes more protracted. Although the paper is motivated by the lockdowns during the Covid-19 pandemic, the framework can be readily applied to large, temporary shocks of different nature.