Question

A shelter in place order is issued instead of market adjustment. How does this affect the short run equilibrium?

Will the economy come back to the long run steady state equilibrium?

Answer 1

The short run equilibrium implies lower price level and lower GDP due to leftward shifts in both aggregate demand and aggregate supply curve.

It is also found that eventually the economy converges to the same final steady state as the impact of any pandemic-induced policy or health changes last as long as the youngest generation in the population that got exposed to the shock is affected.

Explanation:

Some individuals in the economy get hit with this unexpected health shock in 2020, become infected, and face a big change in their survival probabilities.

Efforts to mitigate the spread of COVID-19 in the U.S. have included closing businesses that are considered unessential. This has resulted in more than 26 million initial unemployment insurance claims within five weeks of the pandemic outbreak. Without large scale testing of the population, it is not clear how much time it will take for economic activity to resume.

It is shown in some studies that there are significant differences in the economic consequences of who to quarantine during this pandemic. We find that stay-at-home recommendations that are based on health and age reduce the economic severity of the pandemic by 10% of GDP as against if everyone regardless of health and age is quarantined.

It may be possible to introduce subsides to the elderly or those with underlying health conditions to self-isolate until a vaccine or a cure is available which might reduce economic burden on them and keep the aggregate demand going. The fiscal consequences of either of these policies is likely to be much lower that what is currently spent on providing unemployment insurance to a large fraction of the working age population.

The nationwide lockdown imposed by many countries restricted business activities and lead to contraction of aggregate demand. The industries such as energy. tourism, hospitality and leisure are suffering greater slowdowns. With zero sales and no work at all, the layoffs are high leading to higher unemployment rate.

There will be huge income losses resulting in decrease of consumption of goods and services, in turn affecting the prospects of business and economies.

Thus, the short run equilibrium implies lower price level and lower GDP due to leftward shifts in both aggregate demand and aggregate supply curve.