Question

In Tutorial 4 we discussed what impact Covid-19 would have upon output in a simple Keynesian model. In this question, we extend this analysis by examining the impact of Covid-19 in the context of the AD-AS model.

a) Suppose Covid-19 reduces the exogenous component of consumption (C), planned investment, IP and exports X. What impact will this have upon the position of our AD andAS curves. Explain your reasoning by using a diagram.

b) Explain how the macroeconomy would adjust to the Covid-19 shock (as described above) in the long run if there was no change in the monetary policy reaction function or fiscal policy in response to the pandemic. Explain your reasoning using a diagram.

c) In response to the pandemic, the government has pursued a policy of increasing payments to unemployed individuals (ie. Jobkeeper). In addition, it has foreshadowed a reduction in taxes in the October budget update. Explain what impact these policies will have upon the macroeconomy with reference to the AD-AS model.

Answer 1

a. Aggregate demand in the economy is the sum of consumption expenditure, investment expenditure, government exoenditure and net exports in the economy. A decline in the exogeneous components of these variables due to pandemic will reduce the level of aggregate demand in the economy. This will lead to leftward shift of the aggregate demand curve. This can be depicted in the diagram below:

Initial equilibrium in the economy occurs at point E1 where AD= SRAS = LRAS. A decrease in aggregate demand will shift the AD curve leftwards to AD' and thus new short run equilibrium occurs at point E2 where both the price level and level of Real GDP in the economy has decreased. The decrease in price level will lead to downward movement along the short run aggregate supply curve in the economy from point E1 to point E2 where Real GDP has decreased below the potential level and there is recessionary gap in the economy.

b. This increases unemployment rate in the economy. As unemployment rate increases, the bargaining power of workers will decrease as compared to the employers and this will lead to reduction in real wage rate paid to the workers which reduces cost of production in the economy and increase profits of the producers which will shift the SRAS curve rightwards to SRAS' and thus new long run equilibrium is established at point E3 where price level has decreased to OP3 and economy is back to the full employment level at Yf and price level has decreased in the economy to P3.

c. The expansionary fiscal policy by the government will increase consumption expenditure by reducing taxes and also increase government expenditure which will shift the AD' curve back to AD and initial equilibrium at point e1 is restored in the economy and economy is at the full employment level with government intervention.