CeBER Working Paper No. 2021-4

Making use of a two-country, two-sector, New Keynesian model with essential and non-essential goods we assess the macroeconomic consequences of a labor supply shock in the Euro Area. Our model incorporates health status in the households' maximization problem which depends on the time devoted to leisure. Health status is linked to the consumption of non-essential goods, such that the demand for non-essentials is decreasing with contemporaneous health. After calibrating the model for the case of Portugal and the rest of the Euro Area, our simulations show that, a labor supply shock affecting only the latter, reduces the demand for non-essential goods, generates inflation in the Portuguese economy and pushes both regions into economic recession, depriving households from essential goods. If the labor supply shock affects both economies, the negative income effect dominates the decreased demand effect for non-essential goods and that stagflation is a plausible scenario. In addition, our calibration scheme allows us to conclude that the asymmetric effects across economies may be due to different price rigidities between sectors and to different production structures between countries.