Question

“COVID-19 Impacton Economy”

Assume the economy of country A is in a long-run equilibrium with full employment. The nominal wage of workers are fixed in the short run.

a)Draw a graph which shows the short-run aggregate supply, long-run aggregate supply, and aggregate demand. Describe the equilibrium point and show each of the following:

i ) Equilibrium output, labelled Y1

ii) Equilibrium price level, labelled P1.

b)Owing to the outbreak of COVID19, the export market of country A has decreased. On your graph in part a), describe in detailsonthe effect of lower exporton the equilibrium in the short run, labelling the new equilibrium output and price level Y2 and P2, respectively.

c)Based on your result in part b), what is the impact of lower export on real wages in the short run? Explain.

d)Show, with a new graph,how the economy will return to its new equilibrium in the long run if the government does not intervene. Explain.

e)Suppose the government decides to increase expenditure on new equipment.

(i)What component of aggregate demand will change?Explain.

(ii)What is the impact on the long-run aggregate supply? Explain.

Remarks : From part a) to e), should illustrate with diagrams, graphs, tables and graphics to support arguments whenever appropriate

Words should be more than 500 words( total of a to e ) .

Please help !! Thank You .

Answer 1

We shall be using Keynesian and Neoclassical framework to analyse impact of COVID-19 on the economy.

Assumptions:

• Economy at full employment (Natural employment) in the long run.
• Nominal wages of workers are fixed.
• The full employment(Natural) rate of output (Y1) is the amount of output the economy produces when unemployment is at its natural rate. LRAS curve is vertical because economy is producing at optimal level. Also, it depends on the economy’s stocks of labor, capital, and natural resources, and on the level of technology. An increase in Prices doesnot affect any of these factors, thus no impact on LRAS curve.
• The SRAS Curve tells us the quantity of goods and services supplied in the short run for any given level of prices. We assume SRAS curve is upward sloping due to sticky wages (Fixed nominal wages) and misperception.

Consider the Diagram,

(a.) As per above figure, the long run equilirium is established at point E1 where equilibirum output is Y1 and equilibirum price level is P1. At E1, all three curves i.e. LRAS, SRAS and AD intersects reflecting optimal state of the economy. Economy is neither producing too much nor too less.

(b.) Now due to outbreak of COVID-19, the demand for exports from Rest of the world declines for Country A.

• Consider, the AD Equation : AD=C+I+G+NX. As per this equation, the net exports of Country A will decline which will cause decline in AD. This implies that AD curve will shift leftwards from AD1 to AD2 in above figure.
• Consequently, the new equilibirum will be established where SRAS curve intersects new AD Curve i.e. AD2 at point E2. The equilibirum output and prices at this point are Y2 and P2 respectively.
• We can see clearly that both output and prices have declined in the short run post fall in the exports demand.

(c.) Since nominal wages are fixed (Assuming sticky wages) and price level have declined due to the fall in AD, the real wages will rise. This implies cost of production have increased for the firms. However, firms will revise the contract later with declined expected price levels.

(d) We can see in the Short run, prices and output are lower than the full employment level. Now we shall use Sticky wage theory to depict adjustment for the Long run. The important aspect of this theory is expected wages. Since price level has declined, the expected price level will be revised downwards. Consequently, nominal wages will fall as firms will revise the contracts based on new expected price level. The decline in nominal wages reduces cost of production. The firms will produce more output at the given level of prices. Overtime expected price level will fall, consequently SRAS curve will shift rightwards to SRAS'.The new equilibirum will be established at point E3 where all the curves( LRAS, SRAS' & AD') intersects. Here economy again reached full employment level with Equibirum prices (P3) lower than the initial full employment level prices (P1).

e)

• If government invest on the equipments, then as per AD equation Investment (I) part will change. Because it encompass gross fixed capital which raises productive capacity of the economy. The investment will shift AD curve to the rightwards and overtime economy will attain the full employment level again.
• The long run aggregate supply curve (LRAS) is determined by all factors of production – size of the workforce, size of capital stock, levels of education and labour productivity. Any changes in the factors shifts the LRAS curve. So, due to increase in productive capacity, the LRAS will shift rightwards.