Question

Advanced Macroeconomics

Suppose that output is at the full-employment level and that nominal wages are slow to adjust. Considering the short-run and long-run effects of the coronavirus on output and the price level, discuss what the government can do to return output to its natural level using the AD-AS framework?

Answer 1

Assume long run output level before COVID-19 is at point A where price level is P and output level is Y. In short run , aggregate demand will fall which will shift demand curve to AD1 from AD1 shifting short run equilibrium from point A to B which reduces of basket of goods from P to P1 and reduce output level from Y to Y1. As nominal wages are slow to adjust, fall in price raises real wages of employees in long run which raise cost for producers and shift aggregate supply from AS to AS1 which will shift economic equilibrium from point B to C which raise price to its initial level and reduce output level further to Y2. It will shift economic long run equilibrium to point Y2 from Y post COVID-19.

Government can adopt expansionary policy by raising government spending and reducing taxes such that people have more money with them to spend on goods and services which raise aggregate demand. Additionally they can take help from Central bank to raise money supply. They can also raise transfer payments, subsidies, unemployment benefits such that economy does not fall into recession.