Consider the economy of a country A working on its long run equilibrium prior to the...

Consider the economy of a country A working on its long run equilibrium prior to the outbreak of COVID-19. Suppose that this country has been badly affected by COVID-19 to date, over the course of past four months, after the first case has been reported.

a) By using an appropriate diagram and your knowledge of economics, show the current state of equilibrium in country A. (Refer to the concepts such as aggregate demand curve, short-run aggregate supply curve, long-run aggregate supply curve, monetary neutrality, recession, depression, stagflation, and unemployment.)

b) Is it possible for this economy return to its long-run equilibrium? Describe the possible outcomes for the next few years taking into account the two forms of policy response, that is, (i) Do nothing and wait for prices and wages to adjust, (ii) Take action by using monetary and/or fiscal policy.

Expert Solution

Before the outbreak of corona virus (covid 19) Country A was on its equilibrium. There was full employment and no output gap was there, Potential GDP was equal to real GDP. But due to the outbreak of covid 19 , there is decrease in income, output and employment. Therefore, short run aggregate supply curve shifts backwards. Due to fall n SRAS equilibrium price will increase from p to p1 and equilibrium quantity will decrease from q to q1.

It is a situation of recession and now real GDP is less than potential GDP. It is a worst situation. To overcome the situation monetary and fiscal policy takes action

Take action by monetary and fiscal policy-

Fiscal policy used by fed is expansionary . Taxes are reduced and spending is increased. Due to that aggregate supply curve will shift rightwards and again full equilibrium will be attained. The reason is expansionary fiscal policy increase production and increase in production provides employment and employment leads to increase in income.

Expansionary monetary policy-discount rate is reduced and central bank buys government securities through open market operations. Increase money supply in banks. Interest rate falls and borrowing becomes cheaper. Investment increases. Increase in investment leads toward increase in production and increase in production provide employment and employment leads to increase in income.

Do nothing and for fluctuations in prices- It will be a difficult situation .government intervention is essential to remove the recession.

Rahul Sunny answered 8 months ago

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