Question

3. Currently, people are staying home due to COVID-19, which clearly limits a lot of the activities that people would normally do. While some people will spend more on online shopping, in general, it is reasonable to think that consumption has fallen.

(There are OTHER changes going on as well, but just focus on this one for this question.)

a. Draw an AD-AS graph. Assume that the economy was at full employment before the virus. Then show the SHORT RUN effect on the economy.  

b. If NOTHING else happens, EXPLAIN how the economy will eventually return to long-run equilibrium. Identify the new long-run equilibrium on your graph.

c. The government has just passed a spending bill which is designed to stabilize the economy. EXPLAIN how this would affect the short-run equilibrium on your graph.

Answer 1

a) the economy is at full employment equilibrium at E. There is a reduction in consumption expenditure due to which aggregate demand curve shifts to left. This has created a recessionary gap in the short run where price level and output level both have decreased.

b) if there is no accommodating policy adopted by the government then economy will self correct itself. During the transition from short run to long run there will be a rightward shift of the aggregate supply curve. This will increase the level of output and bring it back to its full employment level at Yf while reducing the price level further to P1

c) With the stabilization policy of the government there will be an increase in the government expenditure or a decline in the tax rates that is likely to shift the aggregate demand of the right. This will bring back the original price level and the original level of output at full employment.