Question

The text book: Robert H. Frank, Ben S. Bernanke, Kate Antonovics, Ori Heffetz - Principles Of Economics 7

Answer this question using the concepts discussed in Textbook Ch. 27 and assume that, initially, the economy is in its long run equilibrium.

“The global economy will contract by 3% this year as countries around the world shrink at the fastest pace in decades, the International Monetary Fund says. The IMF described the global decline as the worst since the Great Depression of the 1930s. It said the pandemic had plunged the world into a “crisis like no other” (BBC News 14 April 2020).”

(a) With reference to the news above and with the help of an aggregate demand-supply diagram, briefly explain how the Coronavirus pandemic may reduce equilibrium global output in the short run.

“The plunge (of crude oil price) started after Russia rejected a proposal by OPEC to cut its crude oil production by 1.5 million barrels a day. In apparent retaliation, Saudi Arabia cut prices for buyers over the weekend (nbcnews March 10, 2020)”

(b) With the help of an aggregate demand-supply diagram, briefly explain how a sudden crude oil price plunge may affect equilibrium global output in the short run.

(c) With references to the two pieces of news above and assuming that the prediction of IMF is correct, briefly explain how the Coronavirus pandemic and crude oil price plunge may affect equilibrium inflation rate and global output in the short run and the long run. Please illustrate your answer with aggregate demand-supply diagrams.

Answer 1

Ans. A) COVID pandemic may reduce output in the short run.

It's a known fact that the COVID pandemic has affected the world economy in a significant way. The pandemic has many factories and firms shut down thus causing a major negative supply shock in the economy. The pandemic has impacted the aggregate demand function as well. The increase in aggregate demand has a positive effect on the economy via increased output, increased employment, and productivity growth. Likewise, a decrease in aggregate demand will have a negative impact on the economy. As a result of the pandemic, the demand for commodities has reduced as many are laid off from work. Due to the pandemic, the productivity of the people decreases. Due to the combined effect of lower demand for commodities, involuntary unemployment, drop in productivity growth the Aggregate demand curve shifts downwards to the left. The supply side of the economy is disturbed as well with the global pandemic. The changes in the aggregate demand curve determine the change in the real GDP or output of the economy in the short run. This combined effect is shown in the below diagram

Due to the demand constraints discussed above, the aggregate demand curve shifts from AD to AD1. Initially, the economy was at equilibrium point e, where the output level was Y and the price level was P. Due to the pandemic and its impact on the demand side the output decreases from Y to Y1 with an increase in the price level. Thus COVID had reduced the output in the short run.

b) Aggregate Demand and Supply and the crude oil price plunge.

When the price of oil falls, the transportation cost and the fuel costs of the firms decrease as well. The decrease in oil prices will have different effects depending on the countries. AN oil importing company will have much benefit when the price decreases. But oil-exporting companies will have decreased revenue. In the diagram, when the oil prices fall the Aggregate Supply curve will shift to the right which causes a lower price level and a higher output level.

c) COVID pandemic and oil price plunge combined effect on output and inflation rate.

The oil price has been the lowest in the economy since 2002, due to COVID. The economic slowdown and the lack of demand for oil are the main reasons for the decrease in oil prices. The oil and gasoline stocks have increased in most of the developing countries.

The combined effect is shown in the diagram where the pandemic causes the demand shock and shifts the Aggregate Demand curve to AD1 from AD. The low demand for oil prices due to the economic slowdown leads to the shift in the aggregate supply curve from AS to AS1. This combined effect affects the global output and price level. The output is reduced from Y to Y1 and the price level is decreased from P to P1 in the short run.