Question

3. Consider an intertemporal model. Suppose that supply and demand are equal initially in the goods, labor, and money market. Due to COVID-19 consumers purchase only small amount of goods and services in the market, although firms can still produce output goods sufficiently.

(a) Draw the labor market(Ns/ Nd), output goods market(Ys/ Yd) and money market graphs (Ms/ Md) and then determine the effect of COVID-19 on the output level(y), the real interest rate(r), the price level(P), employment(N), and real wage(w).

(b) Draw and describe what happens in all the variables when the central bank raise the money supply.

(c) Draw and describe what happens in all the variables when the fiscal authority raise the government spending.

(d) Compare these two policy choices and explain the difference in detail

Answer 1

(a) Labor Market

In the labor market, due to industries and economy in general closing down due to Covid 19, the labor demand would go down. Due to this, the earlier equilibrium wage rate, which was at W, will fall to W'. This would also lead to fall in overall employment level in the country.

Output Goods Market

As mentioned, consumers are now purchasing small amounts of goods and services in the market. Thus, the AD curve would shift to the left. This would lead to fall in real output in the economy. SRAS curve and AD curve will now meet at less than optimum level of GDP and the price level will fall to P'.

Money Market

Now that the general consumption is down, the demand for money in the economy for consumption and investment will fall down leading the money demand curve to shift to the left. This will lead to fall in interest rates in the economy to I'.

(b) If the central bank raises the money supply, the money supply curve will move to the right to MS*.

This would lead to slight redemption of the interest rates to a higher level I*. Interest rates would still not go back to earlier level since money demand is at a reduced level.

(c) If the government increases the fiscal spending in the short term, SRAS curve will move right to SRAS*.

This would lead to expansion in output and it will move closer to the potential GDP level. The price level however will fall down further to P*, unless demand is sufficiently stimulated.

(d) When the government increases fiscal spending, the impact is felt directly by the consumers by way of increase in consumption. Money market operations usually impacts the investment function more than consumption. While both are beneficial for the economy in times of recession, direct government spending is likely to have more impact.