Question

3rd year Macroeconomics Question

(a) Suppose that output is at the full-employment level and that nominal wages are slow to adjust. Using the AD-AS framework to explain the short-run and long-run effects of the coronavirus on output and the price level. (Hint: How does the coronavirus affect the short-run and long-run aggregate supply curves and the aggregate demand curve?)

Answer 1

In the short-run, the price level of goods will increase and the output will fall below the level of full employment.

In the long run, the price will increase and the output will remain lower than the output level at which the economy starts.

Explanation:

In the short run, the aggregate supply curve is upward sloping because some factors of production are fixed and the nominal wages are slow to adjust. In the long run, the supply curve is vertical which shows the potential output of the economy, that is, the full-employment level of output.

If the output is at the full-employment level, then the output is equal to the potential output. It means that the short-run supply aggregate curve, the aggregate demand curve, and the long-run aggregate supply curve intersect at the same point at the output, Y = Yf (Full employment level), and the price, P.

Effects of coronavirus in short -run:

Due to coronavirus, the world economy has witnessed shifts in both the short-run aggregate supply curve and the aggregate demand curve toward leftward. The supply curve shift occurs because the workers are not working due to coronavirus and the overall supply in the world is reducing. The demand curve shifts as household's income reduces due to unemployment, thus, the demand reduces. Since the primary effect of the virus is on the supply side and the nominal wages are low to adjust, the supply curve's shift is more than the demand curve's shift. Thus, in the short-run, the prices of goods will increase and the output falls below the full employment level.

Effect of coronavirus in the long-run:

The output level generally is at full employment level in the long-run. In the long-run, both the aggregate supply and the aggregate demand will increase as the economy starts to adjust itself. However, supply curves shift to right with very small amounts as wages are low to adjust and the economy will recover slowly. Also, due to coronavirus, lots of lives have been lost, and as a result, the productivity of resources will reduce and the long- run aggregate supply shift to left and potential output will reduce until the long run-supply becomes equal to the supply and economy will attain at full employment level. This will increase the price little more and the output will increase than the short run output but remain lower than the output level at which the economy starts.