Question

(Please attach a graph showing your work for question 2)

Suppose that the coronavirus pandemic (COVID 19) in 2020 has resulted in a leftward shift of the aggregate demand curve (it has also shifted the short-run aggregate supply to the left, but let’s ignore this effect here for simplification).

A. Use the aggregate-demand/aggregate-supply model to show the effects on output and the price level/inflation in both the short run and long run (assume that the short-run aggregate supply curve is upward sloping). (2 points)

B. Show the adjustment process of the economy from the short run to the long run. (2 point)

C. What is the effect on unemployment in short run and long run? (1 point)

D. Can policymakers use monetary policy (and/or fiscal policy) to accommodate this shock? Describe what happens to the economy in response to this policy action. (1 points)

Answer 1

a) Leftward shift in demand curve will shift demand curve from AD to AD1 which will reduce price level from "P" to "P1" and reduce output level from "Y" to "Y1".

b) In long run, producers will reduce their production of goods because there is fall in aggregate demand in short run to avoid inventories of goods. It will shift aggregate supply curve to its left from AS to AS1 which will raise price level to its initial level while output level fall further.

c) Unemployment level will fall even in short run as well as long run because of fall in output.

d) Policy makers can use monetary or fiscal policy in short run to raise aggregate demand. Expansionary Fiscal policy raise government spending and reduce tax which will raise disposable income left with consumers and raise aggregate demand or Expansionary monetary policy which raise cash holdings with people which tends to raise willingness to pay for goods which will eventually raise aggregate demand.