Question

a) Analyze what has happened in the economy since late March, due to restrictions put in place to control the widespread contamination by COVID 19.

b) Carefully analyze the likely effects of government's Fiscal and Monetary Policies. Use graphs if you need to analyze the two types of policies and their efficacy.

c) Assess the Short-run and long-run economic consequences.

Answer 1

A) As the Corona Virus pandemic is spreading slowly and gradually across most parts of the world, the end result is that people have started demanding lesser. This is because all stores and establishments are closed and only those that provide essential services have been allowed to stay open. Over time, as stores and establishments remain closed, and the demand for goods and services remain extremely low, the end result is that people have begun losing their jobs. Unemployment in the economy is rising as business owners make constant losses over the quarters and have not been able to open up and sell their goods or services. The prices of goods other than essential commodities is falling rapidly and the Aggregate Demand which is the total demand in any economy as well as the Aggregate Supply is losing value over the years.

It is estimated, that the Gross Domestic Product or the value of finished goods and services across most countries in the world will fall sharply and a global recession is estimated to hit all countries very soon.

B &C)

The likely effects of this is that both the Federal Reserves of countries as well as the Government would look forward to increasing the demand for goods and services as recession cycle begins to kick in. The following are the key measures which will be taken using the two policies and their explanation is given as follows: -

1) Monetary Policy

The Monetary Policy is set by the Federal Reserve which is the central banking agency of the United States. Due to the pandemic, it is estimated that the Federal Reserves across the globe would deploy an expansion measure in which they will increase the flow of money in the economy. This is done by three core operations which the Federal Reserve has.

!) Decreasing the Cash Reserve Requirements. The cash reserves are the minimum amount of money which the commercial banks must hold at any given point of time with the Federal Reserve. Reducing this would mean that more money is in circulation which would increase the demand and stabilize the economy in the long run. In the short run even if recession exists.

2) Similarly, the Federal Reserve also will alter the discount rate. This is the rate at which the federal reserve grants loans to the commercial banks. Lowering this rate makes it easier for commercial banks to be able to raise capital and lend more freely.

3) The other core operation that is expected is buying of federal bonds in the open market operations. Through this, the federal reserve purchases bonds from banks which is then provided with money for the same. This increase the liquidity for people and accordingly the flow of money in the economy increases substantially.

2) Fiscal Policy: -

The fiscal policy is supposed to be the same as the Monetary Policy. The Fiscal policy represent government expenditure and taxes. Over time, the Government will increase its spending and reduce taxes so as to maintain the demand in the economy, this is done so as to ensure that the economy remains stable and the prices can be controlled so that the GDP does not fall any further.

For example, the government of United States has already given relief packages as high as 2 trillion dollars to revive the economy and to increase consumer spending. Tax reliefs are also expected and will help in making the economy more stable.

The short run effects of this would be that post lock down the demand and supply would begin to increase and would stabilize over time and return back to normal in the long run. A graph explaining the same is as follows: -

Here we represent the effects of Monetary as well as Fiscal Policy in both the short run and the long run. In the short run, the effects of both the policies would be that the Real GDP shifts from point Y1 to point Y2. further the price rises from point P1 to point P2, indicating that the prices begin to rise. The demand curve is downward sloping while the supply curve is upward sloping this is because as prices fall demand rises and vice versa happens with supply.

Over time. in the long run the demand curve would shift to AD3 and this would further increase prices and Real GDP. would rise to a level wherein the aggregate supply cannot be increased any further. This is the point of maximum supply which can be arranged in any economy in the long run.

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