Question

Question 1: As the 2020 pandemic rages on and countries around the world work their way through various stages of shutdowns and re-openings, these countries are experiencing a historic adverse spending shock. Recent early successes in vaccine development have raised hopes for this shock to be temporary, and already there are signs that spending could return to its ‘normal’ levels as early as 2021.

On the inflation front, in many countries although there is some limited evidence of specific products being hoarded and isolated accounts of price-gouging, there is no evidence of wide-spread price or supply shocks.

No lags: show the effects of a temporary, one-period decrease in domestic spending in 2020, where the Bank of Canada (BoC) follows countercyclical monetary policy.

NOTE: For the question on the following pages, call the initial pre-shock point: A; and call the after-shock point: B. I should see (only) points A and B in both the graphs on the left side (where you show the shock on the AE curve on the above graph, and on the Phillips curve on the lower graph: both drawn and labeled carefully). In the first part illustrate the shock described in the question using the AE/PC model without time lags as shown in Ch.12 in the textbook (use the AE and PC graphs similarly to the textbook). For your analysis, choose as a starting point (marked A) an economy operating at potential GDP and at its inflation target. Also on the left side show point B where the economy is situated after the shock but prior to any BoE policy response.

There should be an A and B on BOTH the upper and lower graphs. If points A and B are the same point then just mark that point with both an A and a B.

Using the two graphs on the right side you’ll show the Fed policy response. Start on the right side, showing starting-point B on both the upper and lower graphs. Indicate where the economy is situated immediately after the described Fed response using a point C.

There should be a points B and C on both the upper and lower graphs, even if they are in the same location. If the response has a stable outcome (if Y=Y* and/or the economy no longer requires more intervention from the Bank of Canada) then you can stop your analysis there.

If the economy hasn’t stabilized then you should continue showing the dynamic changes. If it’s appropriate, you can use a point D to show the final stable position of the economy. You may also want a point E in case point D is still transitory.

An important point with respect to timing is that even if the policy response happens in the same time period as a shock, the shock happens first, and then the response follows! The response may or may not neutralize the shock, but that is the sequential order of the two.

If the economy returns to its initial long-run equilibrium position then mark either C=A or D=A, or E=A, whatever is appropriate for your analysis, so that I can see that you have found that outcome. If the economy doesn’t return to its final resting point then I shouldn’t see that marking.

Note: If you have a letter on the top graph you must indicate the associated position using that letter on the bottom one (so if there is an ‘X’ on the top graph then there must be an ‘X’ on the bottom graph. As an example of a common error: if B is located at Y>Y* on the upper graph then it makes no sense to have B at Y=Y* (or Y<Y*) on the lower graph as this would suggest that B is associated with both a boom and at potential (or a recession) at the same time, which is contradictory.

Mark the axis, name the curves, and be neat, clear and organized.

Question 2: Consider the same shock as in the previous question but with lags, as seen in chapter 13. Now assume the policy response is non-accommodative. An important thing to consider in deriving your solution here (with respect to the timing of the policy response) is that it is NOT forward-looking. The BoC implements its policy reaction at the time that it observed that the policy objective isn’t being met (so in other words, when the targeted metric isn’t at its targeted level).

Note: please clearly mark above the line where we can see the shock(s) and also where the BoC policy response is. Use the words “Shock” and “Policy” to communicate to me where you think these are being depicted.

Answer 1

PANDEMIC SHOCK

Left side Graphs---

AE-PC Model-----

#Upper left graph------

Aggregate Expenditure model can be well be well presented by Keynesian Cross.

Look at the above upoer left graph which shows the initial economic situation before pandemic as shown in point A,where long run aggregate supply ( LRAS) curve, short run aggregate supply ( SRAS) & aggregate Expenditure ( AE) curves Intersect each other and show that real gdp equals potential gdp

- point B on the same graph shows the equilibrium point after shock when the decrease in consumption spending has led to downward shift of AE curve and results in decrease in real output and AE

# Lower Left Graph-----

Phillips curve midel which shows the relationship between inflation rare and unemployment rate initially shows natural rate of unemployment ( NAIRU) as in vertical graph where the economy prevails. The Equilibrium point A depicts preshock point and point B shows After shock situation where decrease in price level due to decrease in aggregate Expenditure has led to fall in inflation rate and consequently increase in unemployment rate

POLICY RESPONSE

Right Side Graphs---

#Upper Right graph------( Keynesian cross AE model)

Look at the upper right graph which shows--

* After the pandemic shock, the BOC initiates the counter cyclical monetary policy ,that is expansionary Monetary policy

* Its instruments like reducing repo rate, purchase govt bonds through OMO and reducing LRR will lead to again increase in AE and as a result the Equilibrium Point will shift to point C and must note that the economy shifts back to initial potential gdp level,so point A= point C

# Lower Right Graph------( PC Model)

* The point B at the graph shows the after shock situation while point C shows the after response situation

* With BOC action to overcome recessionary conditions by implementing expansionary Monetary Policy, there will be decrease in unemployment rate as determined by point C ,so the economy reaches back to natural rate of unemployment .