Question

The economic fallout around the world due to Covid-19 could cause recessions in the developed countries. Pakistan being an under developed country is also facing it. Suppose that Government of Pakistan decides to increase its spending by using fiscal policy. But at the same time, Government also wants to control inflation in the economy. Which policy mix would you suggest for the Government of Pakistan? Support your answer with reasons and also draw labelled graphs. (10)

Answer 1

the covid-19 pandemic has wrecked economies all over the world and Pakistan is no exception. Pakistan is also facing negative demand and supply shock which has reduced the GDP. There is a decrease in supply as workers can not come to work due to health and safety reasons as well as government lockdowns. There is a demand shock as many firms become unprofitable and lay off workers. There is a reduction in the purchasing power for these workers which reduces their demand and thus the aggregate expenditure in the economy. As such there is an urgent need to stimulate the economy.

Now Pakistan while wanting to stimulate growth is also worried about inflation and the policy has to be such that an increase in output takes place without raising inflation by much. This can be achieved as follows. The fiscal policy can be aimed at expanding demand. This can happen through reduced taxes for consumers, increased unemployment benefits, minimum basic pay to the poorest sections of the society, and investing in healthcare so that the pandemic subsides as soon as possible. All these measures will shift the aggregate demand curve to the right. Now this expansionary fiscal policy has to be accompanied by expansionary supply-side measures through easing monetary policy. Since a lot of businesses are cash-constrained, they should be given government-backed loans. There should be a reduction in the interest rates charged on firm borrowing which will spur borrowings and investment. All these measures will shift the aggregate supply curve to the right. thus, if both AS and AD shift to the right, the output will increase for sure, but the inflation will not. In fact of the increase in supply is relatively more, the prices can actually fall. But overall this mix of fiscal and monetary policy will help Pakistan achieve the required objectives.