Question

In an earlier interest rate announcement, a central bank in the country Sunshine announced that it believes that the outbreak of the corona virus should reduce global growth in the world economy.

a) Interpret it as the drop in foreign GDP (Y *) and analyze the effects on a country's economy in the short and medium term, using an AS-AD model for an open economy. For simplicity's sake, suppose that Y = Y_n initially and that the real exchange rate is not affected by the case in Y *.

b) Illustrate with the help of a figure how the price level in a country changes over time in question a).

c) Think about monetary policy and analyze in the same type of AS-AD model how you think the central bank should act in connection with the outbreak of the corona virus.

Answer 1

When there is a drop in foreign GDP(Y*) then there is a direct impact on the domestic country's GDP as the foreign GDP decline the foreign country try to take out the  FDI which has been invested in the domestic country.. so here, in this case, the exchange rate is unchanged as both the foreign and domestic country affected by the virus. So when there is a change or drop in a foreign GDP so domestic GDP also drops. As FDI decreases the Supply also decreases. so in this situation the Real GDP decrease to Y2 and Price increase to P1. here as the foreign investment withdrawal that affects the demand also the corona effect so the new AD is AD2 where supply also responds to these two effects and decrease so the new economic scenario is a decrease in demand with an increase in price.

b) The impact of change in real GDP of the domestic country with relation to foreign country GDP has decreased in the first equation which indicates there is no change in the foreign exchange rate, which might be due to the equal rate of decrease in GDP. Here the impact also has on price which shows an increase in nature.

c) So to overcome this type of situation the government took some monetary measures to retrieve the Real GDP to its original position. So it may reduce the tax or print new money to do so.  so in this case government want to support the industry by giving them a low-interest rate for the loan by selling bonds. supply money to increase the purchasing power of consumers. and tax reduction will increase disposable income.