Question

In Tutorial 4 we discussed what impact Covid-19 would have upon output in a simple Keynesian model. In this question, we extend this analysis by examining the impact of Covid-19 in the context of the AD-AS model.

a) Suppose Covid-19 reduces the exogenous component of consumption (C), planned investment, IP and exports X. What impact will this have upon the position of our AD andAS curves. Explain your reasoning by using a diagram.

b) Explain how the macroeconomy would adjust to the Covid-19 shock (as described above) in the long run if there was no change in the monetary policy reaction function or fiscal policy in response to the pandemic. Explain your reasoning using a diagram.

c) In response to the pandemic, the government has pursued a policy of increasing payments to unemployed individuals (ie. Jobkeeper). In addition, it has foreshadowed a reduction in taxes in the October budget update. Explain what impact these policies will have upon the macroeconomy with reference to the AD-AS model.

Answer 1

a. A decrease in the exogenous component of Consumption, planned investment and exports will reduce the level of aggregate demand in the economy. A reduction in the level of aggregate demand will shift the AD curve leftwards to AD' and new equilibrium will shift from point E1 to point E2 where equilibrium price level has decreased and equilibrium level of Real GDP has decreased in the economy. This causes recessionary gap in the economy. The diagram is depicted below:

b. In the long run, this increases unemployment rate which increases bargaining power of employers and this leads to reduction in real wage rate in the economy. A reduction in real wage rate will reduce cost of production in the economy and shift the SRAS curve rightwards to SRAS' and new equilibrium occurs at point E3 where the level of prices has decreased to OP3 and the real GDP is back to the full employment level at Yf. This eliminates recessionary gap in the long run.In the diagram above, it is shows by the pink line.

c. The expansionary fiscal policy of the government will shift the the AD' curve back to AD and initial equilibrium at point E1 is restored with economy at full employment level and price level at P1.