# **1 Introduction**

The goal of this paper is to quantitatively evaluate the ripple effects of temporarily shutting down a large part of the economy, as implemented by many countries in response to the Covid-19 pandemic. How long does it take for the economy to go back to normal once the shutdown is lifted? What explains the cross-country differences in the depth of the recession and the speed of the recovery? Do negative balance sheet effects or labor market frictions significantly slow down the recovery? Which firms are more affected and which ones recover faster or slower? How do the macroeconomic and firm dynamics change if the temporary shutdown shock generated lasting changes in some industries, to which firms adapted?

Our quantitative analysis is motivated by the Covid-19 recession that started with the shutdown of nonessential, contact-intensive businesses in the second quarter of 2020.<sup>1</sup> The ideas in the model we propose, however, go beyond the case of a pandemic-induced shutdown. They apply to other large temporary shocks, such as natural or nuclear disasters, wars or other events that severely disrupt parts of the economy for a short duration of time.

We answer the above questions using a model economy with entrepreneurial production subject to financial and labor market frictions. In our benchmark quantitative experiment the shutdown shock causes a short-lived V-shaped recession with small persistent effects if (i) workers on temporary layoff can be recalled by their previous employers without having to go through the frictional labor market and (ii) laid-off workers receive unemployment insurance. An equivalent institutional setup that yields a quick recovery is one where nonessential workers remain employed and the government pays the wage bill of shut down firms. A longer lockdown or one that shuts down a larger part of the economy has a predictably larger impact for longer periods, but the economy still rebounds quickly after the lockdown ends. Rigid labor markets policies without balance sheet support result in more protracted recoveries.<sup>2</sup> It is possible that the temporary shutdown shock can lead to lasting changes in people’s and firms’ preferences and behaviors. The idea is that the pandemic renders some goods and services less appealing (e.g., cruises) and others more appealing (e.g., teleconferencing and online shopping, including food and grocery delivery) to consumers in a permanent way, and some firms adapt better to new practices. We model this as a permanent reallocation shock that reshuffles productivity across firms without affecting their average productivity.<sup>3</sup> We

> 1Nonessential contact-intensive industries represent 25% of final demand and 35% of employment in the US (Leibovici et al., 2020). GDP in these industries fell by 40% to 54% between the end of 2019 and the second quarter of 2020. Consumption of transportation services, recreation services, and food services and accommodations fell by 41, 54, and 40 percent, respectively, between 2019Q4 and 2020Q2.

> 2This result extends to small open economies with tighter financial frictions.

> 3Barrero et al. (2020) report evidence of expected reallocation shocks using data of expected sales and

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