Question

We have decelerating inflation of 1.2% based on CPI index in Q2 2019-20 with declining growth in consumption, investment and net exports compared to Q2 2018-19. The growth rates of components of AD curve have shown sustained decline in the last few quarters.
The natural rate of unemployment has risen from 5.1% to 10.2% from Q2 2018-19 to Q2 2019-20.
The capacity utilization of core 8 industries has decreased from 96% to 76% from Q2 2018-19 to Q2 2019-20.
i) What can you tell about the character of such an economy? Please use the AD, SRAS and LRAS framework to display the movement in output and inflation levels in this economy.
ii) The government is worried about the situation of falling growth and it plans to conduct appropriate fiscal policy in the short run. However, it does not want the revenue deficit to increase. Suggest a specific action which ensures recovery of the economy while keeping revenue deficit unchanged. Show the effects using AD, SRAS, LRAS framework.

Answer 1

Hi,

Hope you are doing well!

Question:

Answer:

AD-AS Model:

Here, AD means Aggregate Demand and AS means Aggregate Supply. It is a macroeconomic concept and tells about the price and total output/GDP through the relationship of aggregate demand and aggregate supply. AD demand is the total demand of goods and services at different price level in a specific time duration. AS is the total supply of goods and services available to a particular market from producers. Aggregate demand is directly affected by the consumption, investment, government spending and net export. When the consumption, investment, government spending and net export increase then its increased the AD in the economy that increase the total output and price level/inflation and vice-versa. AS is affected by the supply of labor, technological changes, change in wages, change in production costs, changes in producer taxes, and subsidies and changes in inflation etc. When labor supply increase, production cost decrease, tax rate decreased by the government, subsidy is increased then its increased the AS and vice versa. Increasing AS increase productivity and employment and increase income level and vice-versa.

Now come on the question:

i). Answer:

As per the question, inflation of 1.2% based on CPI index in Q2 2019-20 with declining growth in consumption, investment and net exports compared to Q2 2018-19. The growth rates of components of AD curve have shown sustained decline in the last few quarters.
The natural rate of unemployment has risen from 5.1% to 10.2% from Q2 2018-19 to Q2 2019-20.
The capacity utilization of core 8 industries has decreased from 96% to 76% from Q2 2018-19 to Q2 2019-20.

As per the data the major macroeconomic indicators-GDP, inflation, capacity utilization has declined from the same quater of the previous year and unemployment has risen from the same quater of the previous year. So, decreased GDP, inflation, capacity utilization and increased unemployment indicate a economic slowdown. It is result of declining growth in consumption, investment and net exports compared to Q2 2018-19. We have seen when AD decline then its negatively affect the GDP/total output and inflation and both are decreased. Other hand decreasing AS decreased the productivity and employment generation that increase unemployment level. So, this data show that economy is in stress and falling down.

ii). Answer:

As per the question, The government is worried about the situation of falling growth and it plans to conduct appropriate fiscal policy in the short run. However, it does not want the revenue deficit to increase.So, the best solution is "Helicopter Dropping Money". It is a large sum of new money that is printed and distributed among the public, to stimulate the economy during a recession. It is a expansionary fiscal policy. It will increase the money supply in the economy that will increase the income level and AD that will boost economic growth and inflation. Other side it will increase the investment level that will increase productivity and employment and increase income level.

But to increase the helicopter money from a standard level can rapidly increase the inflation rate or create a hyperinflation level in the economy that will negatively affect the economic growth and employment level in long run.

Now we will understand the all these things through the graph.

First situation (for question number-i)-

Suppose currently is at equilibrium stage at the point "E1" where total output is "Y1" and price level is "P1". Now consumption, investment and net exports level decrease then aggregate demand will decreased in the economy taht will shift the AD curve down ward/ right from "AD1" to "AD0" then new equilibrium point will be "E0" and total output will decrease from "Y1" level to "Y0" level and price level will decreased from "P1" to "P0" level.

Second situation (for question number-ii)-

Suppose currently is at equilibrium stage at the point "E0" where total output is "Y0" and price level is "P0" suppose government increase money supply through the "Helicopter Dropping Money" that will increase consumption, investment and net exports level. increasing consumption, investment and net exports level will increased the aggregate demand in the economy that will shift AD curve up ward from/left from "AD0" to "AD1" then new equilibrium point will be "E1" and total output will increase from "Y0" level to "Y1" level and price level will increased from "P0" to "P1" level.

I have attached the graph. Please find the attachment.

Thank You