Question

Starting from a long run equilibrium show the short run impact of COVID 19 (short term temporary supply shock) on output and price level graphically and explain the mechanism of these changes. Suppose in the initial long run steady state equilibrium output is 22 trillion dollars and the price level is 100.

Answer 1

The economy starts at the point A where the long run equilibrium is achived by the intersection of the AD, SRAS and LRAS curve. At the long run equilibrium the price level is 100 and the output is 22 trillion, then the Covid-19 pandemic hit the economy so there is a massive decline in the production because of the lock down procedures many firms are forced to shutdown or reduce their production. This is a negative temporary supply shock and this will decrease the short run aggregate supply, the decline is shown by a leftward shift of the SRAS curve. The short run aggregate supply curve will shift from SRAS to SRAS1 , as the supply decreases this will put upward pressure on the price level and real GDP of the economy will decrease. The economy will move from the long run point A to the short run equilibrium point B. Now the economy is having a recessionary gap, a recessionary gap oocurs whenever the current real GDP falls below the full employment level of output.