Question

Use the Aggregate Demand and Aggregate supply model to explain the current crisis on the coronavirus. Explain the current economic contraction without talking about the government and Federal Reserve responses. Start with talking about how AD and/or AS would be affected by social distancing measures which means that people would stay home, unemployment rises, and non-essential business close.

Answer 1

Ans. Suppose the economy is in longrun equilibrium with output Y and price level P. The coronavirus crisis would lead to a decrease in consumption because people are not consuming non-essential goods right now and private investment due to pessimism because businesses are closed for non-essential goods leading to decrease in aggregate demand shifting the AD curve to the left from AD to AD’. Also, as the global supply chains have been interrupted, so, input costs will rise leading to increase in cost if production which leads to decrease in aggregate supply shifting Aggregate supply curve to the left from AS to AS’. The combined affect of both these shifts is decreased output from Y to Y’ and as output has fallen below the level of full employment, so, unemployment rate also increases above the natural level. But the affect on price is ambiguous as bot supply and demand side has been affected and this may vary from country to country depending on which side is more affected i.e. if decrease in aggregate supply is more than decrease in aggregate demand then price level will increase and vice versa.

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