Question

Situation: Suppose a large portion (approximately 20%) of the United States decides that the COVID-19 epidemic is a sign of the coming apocalypse within the month (assume they are wrong). Approximately half of this group decides to spend all their wealth on doomsday preparation and charitable acts. The other half of this group decides that the world is doomed, there is no hope of fighting it and decides to party and have as much fun as possible for the next month.

1. Using words (and math if you’d like) describe the macroeconomic impacts of these groups’ actions. What will be the impact on total, consumption, and investment spending, net exports, and the price level? Will interest rates be affected? If so, how?
2. Graph the changes described in your answer to question 1. Use all appropriate graphs in your answer (AD-AS, Supply and Demand, Loanable Funds Market, Money Market, etc.).
3. Based on your answer to question 1:
a. What is the appropriate governmental policy response, if any, after a month has passed and each group is proven wrong? Defend your answer.
b. What will be the impact on total, consumption, and investment spending, net exports, and the price level? Will interest rates be affected? If so, how?
4. Graph the changes describe in your answer to question 3. Use all appropriate graphs in your answer (AD-AS, Supply and Demand, Loanable Funds Market, Money Market, etc.).

Answer 1

1. The population of United States is 328.2 million. Now, 20% of them, that is, 65.64 million people believe that COVID-19 epidemic is the sign of coming apocalypse within the month. Half of this group, that is, 32.82 million people decide to spend all their wealth on doomsday preparation and charitable acts. In this case, for doomsday preparation, people will buy commodities for one month. This will not have a noticeable effect on consumption since people anyway have stored or buy a months' supplies in one go. They also seem to be spending all their wealth on charity. Now this will lead to significant reduction in savings and investment spending since the money they might have used for investment has now gone to charity.

The other 32.82 million people decide that the world is doomed and party and have as much fun as possible. This can lead to a significant rise in overall consumption because people are out every day and every night spending on things like clubs, drinks, and what not. In this case investment would decilne since all the money the people have is being spent, and not saved - since they want to have as much fun as possible in this short duration of time. In this case price level will go up, because when consumtion increases, inflation also rises.

In both the cases, since investment is falling, the interest rates will rise. Also, in both cases, there would be minimal impact on exports.

2. The Average Demand curve will shift to the right with increased consumption. This will shift the equilibrium to a higher price level.

Since investment has declined, the quantity of loanable funds available will also decrease shifting the curve to the left. New equilibrium will be at a higher interest rate.

Since the quantity of money available in the economy is declining, the Money Supply curve will shift to the left, meeting the Money Demand curve at a higher nominal interest rate.

3. a. If a month has passed and both the groups have proven to be wrong, the government first has to deal with increased prices and increased interest rates. Increased consumption would have caused widespread inflation. The govenment then should reduce its own spending to bring the prices under check. Because the loanable funds were few, the interest rates increased. The govenment now must encourage people to save more by way of increasing the savings rate so that loanable funds beome available and pressure on interest rates is eased.

b. After the govenment response, the total consumption should come to normal levels, investments should increase, pressure on prices and interest rates should ease and they will come to pre spending levels. The net exposrts should behave as they did before.