Question

Incorporating COVID-19 pandemic into the AS/AD model

Q. What are the optimal policy responses to the pandemic shocks (what would you do as a policymaker)?

Show monetary and fiscal policy responses in a new diagram, and discuss other relevant policies

(focus on macroeconomic and microeconomic policies, do not go into health and social policies although they are also important).

Answer 1

The Corona Virus Pandemic has caused great concerns among the economic community primarily because of the numerous shut downs which have been implemented across the globe by all major countries.

The end result of such lock downs is that the overall aggregate demand falls as people are forced to stay at home and cannot purchase anything except for essential items, as supply lines have been shut and  companies have been told to halt production and let people be at their homes to avoid spread.

The end result of such excercise economists fear is that companies may fire people from their work and this can lead to degradation of the employment opportunities available to people. Further the aggregate demand can dry out and so can the aggregate supply, pushing down the overall GDP of the country and creating big problems for the economy respectively.

The optimum Monetary and Fiscal Policy would be of expansion which increases the flow of money back into the economy and creates demand whenever the market is up and running again.

Monetary Policy

In a situation like this, if i were a policy maker which sets in the Monetary Policy i.e, working in the Federal Reserve or the Central Bank of the country, then my ideal strategy would be to reduce the Cash Reserve ratio which is the minimum amount of money which the commercial banks must hold with the Federal Reserve so that liquidity of money in the economy can increase. The additional capital supply creates an opportunity for banks to reduce the interest rates and increase credit supply which has positive effects on the economy,

Further policy measures would include reducing the interest rates which are charged by us to the banks. These directly impact the banks interest rates which if lowered can help in people getting easier credit and increasing their aggregate demand respectively.

Another method could be purchasing government bonds in the market. These bonds once bought lead to creation of additional capital as they infuse the economy with extra money.

Fiscal Policy:-

On the fiscal front, if i were a policy maker, my focus would be to reduce the taxes which are charged by the government. Further i would increase the amount of investment which is there by the government as a policy measure to ensure the generation of capital and revenue in the economy.

When the country has additional money in the form of reduced taxes and increase in expenditure brings in positive results, the country may be able to increase its overall aggregate demand and supply respectively.

A diagram explaining the same is as follows:-

In the diagram above we can see that as a result of the Corona Virus Pandemic, the Aggregate Demand as well as the Real GDP fall from level P to P1 and Y2 to Y1 indicating a shift in the demand curve. If we continue to expand business, we may be able to shift back to a level at AD or to AD2 if the aggregate demand goes on to rise after admission of the expansionary policies of the government respectively. The Aggregate Supply curve on the other hand will continue to rise, until it reaches the point where aggregate supply becomes constant unless new technology is deployed.

Please feel free to ask your doubts in the comments section.