Question

Assume that the economy starts at the 'natural rate of output'. Now suppose there is a decline in net exports due to the global economic downturn caused by COVID-19. Using the AD-AS diagram to show the effects in the short run and the medium run on the output, employment. and the price level. show how expansionary fiscal policy may influence these equilibrium positions.

Answer 1

The economy starts at the 'natural rate of output'.:-

An economy's natural level of output occurs when all available resources are used efficiently. It equals the highest level of production an economy can sustain.

In other words the long-run an economy that is in a in recession or overheated must return to its natural level of production. The economy is at its natural level of production when all the factors of production, including labor are being used efficiently, but not stretched beyond their capacity.

Decline in net exports due to the global economic downturn caused by COVID-19:-

The COVID-19 recession is a major ongoing global economic crisis which has caused both a recession in some nations, and in others a depression. It is currently the worst global economic crisis since the Great Depression. The economic crisis began due to the economic consequences of the ongoing COVID-19 pandemic.

Economic activity among advanced economies is anticipated to shrink 7% in 2020 as domestic demand and supply, trade, and finance have been severely disrupted. Emerging market and developing economies (EMDEs) are expected to shrink by 2.5% this year, their first contraction as a group in at least sixty years. Per capita incomes are expected to decline by 3.6%, which will tip millions of people into extreme poverty this year.

Trade was already slowing in 2019 before the virus struck, weighed down by trade tensions and slowing economic growth. World merchandise trade registered a slight decline for the year of ‑0.1% in volume terms after rising by 2.9% in the previous year. Meanwhile, the dollar value of world merchandise exports in 2019 fell by 3% to US$ 18.89 trillion.

The JP Morgan global PMI for March showed export orders in manufacturing sinking to 43.3 relative to a baseline value of 50, and new services export business dropping to 35.5, suggesting a severe downturn.

The AD-AS diagram to show the effects in the short run and the medium run :-

output

 In the short run, output can be above or below the natural level of output. Changes in any of the variables that enter either the aggregate supply relation or the aggregate demand relation lead to changes in output and to changes in the price level.

 In the medium run, output eventually returns to the natural level of output. The adjustment works through changes in the price level.

This economy was initially at long-run equilibrium, so its current output (Y_1Y1​Y, start subscript, 1, end subscript) was equal to its full employment output (Y_fYf​Y, start subscript, f, end subscript). As the result of an increase in one of the components of AD, the entire curve will increase (shift to the right). At the old price level, AD would exceed SRAS. This excess demand puts upward pressure on the price level until the economy assumes a new short-run equilibrium at a higher price level (PL_2PL2​P, L, start subscript, 2, end subscript) and higher output (Y_2Y2​Y, start subscript, 2, end subscript). Because output has increased, the unemployment rate has decreased.

How expansionary fiscal policy works:-

If the government cut income tax, then this will increase the disposable income of consumers and enable them to increase spending. Higher consumption will increase aggregate demand and this should lead to higher economic growth.

Alternatively, if the government increased investment in public work schemes, this government spending would create jobs, increase incomes and lead to greater aggregate demand.

Expansionary fiscal policy can also lead to inflation because of the higher demand in the economy.