Question

Its purpose is to provide you an opportunity to demonstrate your ability to think like an economist by applying economic principles to interpret the logic of a real-world phenomenon.

Please identify any ONE of the monetary policies during COVID 19 in the world, use macroeconomic theories to demonstrate the economic logic behind this monetary policy. Also, please discuss how different schools of economics think of this monetary policy. Do you agree or disagree with this monetary policy? Please use the diagrams and equations to illustrate your opinion.

Answer 1

The COVID-19 pandemic has brought the world to a complete standstill. Demand for goods and services has decreased drastically due to the presence of a lockdown. The economy as a whole is running at a lower capacity and isn't performing at it's maximum potential. Now to understand this let us present a graph:

LRAS: Long Run Aggregate Supply Curve , SRAS: Short Run Aggregate Supply Curve, AD: Aggregate Demand , Yfe: Quantity of goods and services demand at Full employment level.

As we see from the above diagram, there is less Aggregate Demand for goods and services produced, due to the pandemic, lockdown and other situations caused by the Virus. There is also a negative output gap ( Y1 - Yfe ). To combat this and to bring the economy at its full capacity, the central bank could engage in expansionary monetary policy. This means, to increasing money supply and reducing interest rates. With this, credit rates are much cheaper and allows for more borrowing thereby increasing money supply into the economy. Also by reducing interest rates and increasing credit, people spend more and buy more goods and services, increasing the aggregate demand for goods and services and restoring the economy back to it's full employment level.

Although a lot of economists think that increasing aggregate demand is very risky as it can lead to an inflationary trend and can bring deficits into the nation's trade balance, raising AD is potentially the best option to aid domestic producers, to create employment, to generate more revenue and to restore the economy at its full capacity. In the short run, supply is difficult to expand as production cannot be increased or decreased immediately. AD is easier to manipulate and is a cheaper measure to correct the economy, instead of raising govt spending and other measures.  So, to help in restoring the economy into its's full capacity, a nation's central bank can implement an expansionary monetary policy where it can increase the overall aggregate demand for goods and services. Let us picture another graph;

In the above diagram we see a corrected economy operating at its full capacity. We see as implementing an expansionary monetary policy, money supply has increased and interest rates have reduced thus making borrowing cheaper. As a result out AD as shifted rightward to a full capacity level (F) and the economy is running at its full employment level and at it's full capacity. Thus an expansionary monetary policy can aid an under performing economy to attain full capacity.