Question

Suppose that Canada is now in a recession triggered by the COVID-19 pandemic, with unemploy- ment and an output gap. We now analyze this situation using a New Keynesian sticky price model that we learned in Chapter 14. In particular, the labor market and the goods market do not have to clear in the New Keynesian model. Note: In this question, you do not need to show how the COVID-19 pandemic affects the economy, i.e., you do not need to compare the economy before and after the COVID-19 shock. Instead, you directly start from the fact that the economy is currently in a recession with unemployment.

1. (10 Points) Draw four separate figures illustrating the labor market, the goods market, the money market, and the production function. Make sure you illustrate clearly that there is unemployment in the economy, and label clearly the output gap in the figure of the goods market.

2. (10 Points) To help the economy recover from the recession, the Bank of Canada has cut the policy interest rate to 0.25%. At the same time, the government expenditure increases: The Government of Canada announced the COVID-19 Economic Response Plan will provide up to $27 billion in direct support to Canadian workers and businesses. Use the four figures to analyze how this combination of expansionary fiscal policy and expansionary monetary policy together helps the economy recover from the current recession by showing its impacts on output, employment, interest rate, wage, and money demand. (Hint: In our lecture notes we analyze the effects of fiscal policy or monetary policy separately, while in this question you are asked to illustrate the effects of these two policies that are implemented simultaneously.)

Answer 1

In new Keynesian sticky price model, prices are tough to adjust. In recessionary period, output and sales both falls. However, it is difficult to reduce wage as workers are unwilling to accept wage cut. Thus, firm chooses to cut costs by reducing number of labors. As a result, unemployment rises. An output gap between potential and actual output arises.

Panel 1 shows the labour market and level of unemploymnet L1L*.Output gap in panel 3 is Y1Y*. In left down corner, panel 3 shows the production function. . Panel 4 is the money market.

When government reduces interest rate, demand for investment increases. Therefore, demand demand for labor also rises to increase production and sales. Therefore, decrease in interest rate increases real money balance in th emoney market and that further enhances aggregate demand. Output and employment level subsequently returns back to their initial level. As wages are sticky reletive to price, there will be no significant change in nominal wage.