Question

When the government shut down the economy in the early phases of the coronavirus scare, we saw a quick decrease in AD. Please use the AD-AS model to answer the following questions:

a. John Maynard Keynes once stated, “Business pessimism is a self-fulfilling prophecy”. Use the AS-AD model to explain why this quote is true in this instance.

b. After this initial shock to the economy, are economists concerned more about inflation or deflation?

c. In theory, how should the government respond? Was the government’s actual response consistent with our model?

Answer 1

a) What John Maynard Keynes mean by the line in the question is that whenever there is pessimism within Business community especially about consumer demand, that is if Business man speculate that demand will fall down, it will eventually become true with market force acting accordingly that is Business man slowly will reduce their spending and this will cause investment to fall down in the economy, eventually causing fall in effective demand. As Investment is a component of effective demand.

As, corona virus started to spread at higher rate and there seems to very little optimism on cure of the virus soon. Almost all countries started to lockdown their economies. The Business community with no availaibility of supply chain and condition across globe started being worse started being pessimistic about economy and was expecting recession. Due to which not only in United States across the globe there is fall in effective demand. As soon as this happened we saw decline in consumer demand as well fall in prices at the time of this crisis.

b) Certainly to understand this we need to know IS LM model of Keynes and how money market works. IS-LM model depicts interaction between goods market and money market which can both be helpful in depiction of an aggregate demand curve. As we have seen there is excess spendings by Governments and by the theory if too much money in the economy is there and chasing few goods it will eventually result in inflation. This is can be explained through IS- LM and AD-AS graphs. Primarily an increase in money supply will cause rate of interest to fall down, with the falling rate of interest the investment will likely to rise and people also tend to consume rather than to save this cause an increase in aggregate demand vastly, and this demand will be larger than the amount of goods produced in the economy cause an inflation.

In the second diagram observe only point where SRAS and AD are interacting as we are only concerned about short run here and not long run. The point c thus denoted the Inflation point.

c)

The government responded in Keynesian manner and yes that is true. Keynes believed government intervention is crucial to overcome economic recession . He also suggest in majority of works about government spending and how it will help to recover economy which have lack of demand. As per Keynes, supply do not create its own demand as economy do not exist in full employment level state, it is opposite to this i.e, demand creates supply of goods. Government infact did exactly this although not through fiscal policy but through monetary policy. Evidently the end paths are same, not the policy part. although this way of government spending is these days also called as Monetary Keynesian.