Question

Given your answers to the empirical section of this problem set (the new policies are Fed cuts rate to zero, launches more bond purchases in historic moves to fight coronavirus), what should we expect to see with aggregate output in the U.S.? With unemployment? Inflation? Illustrate your answers using a graph.

Describe how the U.S. economy would go back to its medium run equilibrium once COVID-19 is controlled. Illustrate your answer using a graph

Answer 1

Due to the pandemic there is a slowdown in the economy an in order to spur growth in the economy, Fed cuts rates to encourage cheaper borrowing, higher investment and hence higher aggregate demand. But reducing the rates to zero, currently, might be helpful but in the long run may spur excessive inflation in the economy. This is evident from the graph below. Due to the pandemic, economy is under negative output gap, and cutting rates shift the AD curve to the right , leading to higher output in the short run and higher prices. This leads to higher inflation and hence lower unemployment as the output has reduced. But, if Fed continues at 0 rates, in the long run, economy may prevail at a very high inflation rate.