Question

The policy tracker page in the IMF website summarizes the key discretionary fiscal and monetary policies that governments are taking to tackle the economic impacts of the COVID-19 pandemic. Consider the following examples.

(a) The People’s Bank of China (PBOC), China’s central bank, has lowered its required reserve ratio for commercial banks by 50 – 100 basis points (one basis point = 0.01%). Discuss how this policy would affect the money market. Using the AD-AS diagram to explain the impact of impact of the policy. (10%)

(b) In U.S., an estimated of US$2.3 trillion (around 11% of GDP) of Coronavirus Aid, Relief and Economy Security Act (“CARES Act”) was passed. It includes tax rebates to individuals, expanding unemployment benefits, and so on. Use the AD-AS diagram to explain the impact of impact of the policy. (10%)

(c) Many governments have adopted policies to help firms and business to avoid bankruptcies and lay-offs, such as offering relief on tax and wage costs and funding banks to lend to firms that are suffering. The main purpose is to avoid the potentially temporary negative supply shocks to become permanent. Discuss why it is important to keep the negative supply shocks temporary. (10%)

Answer 1

First, let us see what's aggregate demand and supply. Aggregate demand is known as the total demand for goods and services in an economy that will be purchased at a given price level. It can be represented with the help of the equation:

AD= C + I + G + (X-M), where, C = consumer demand of goods and services, I= Investment spending

G= Government spending, X= exports and M = imports.

Aggregate supply is the total supply of goods and services in the economy at a given price level. So, both monetary and fiscal policies can impact the AD and AS. Now, let us see the specific scenarios:

a) The Reserve Ratio is the specific amount of reserved liabilities which commercial banks are required to hold onto, rather than lending out or investing. It is also known as the cash reserve ratio. This portion of the deposits have to be kept in the form of cash by the commercial banks as directed by the .central bank. When the PBOC has reduced the required reserve ratio by 50-100 basis points for the commercial banks, it implies that the government wants to increase the money supply in the economy. Lowering this ratio would put higher funds into the hands of the commercial banks to disperse. They could lend out more loans, hence, increasing the money supply in the economy. This creates incentive for the businesses to borrow and positively affect investment through increasing employment. Consumption seems to be more attractive than savings and aggregate demand increases. This will shift the AD curve to the right. Also, the higher supply of money in the economy leads to upward movement .along the AS curve. This results in higher prices, higher potential real output, decrease unemployment and increase inflation. This expansionary monetary policy seeks to promote economic growth.

We can take a look at the effects in Fig 1.

b) This example is regarding fiscal policies being undertaken by the US govt. Fiscal policies are the ones which involve instruments like government spending, tax rate etc. Now, expansionary fiscal policies like increasing government spending, tax rate cuts, employment benefits etc. is done in response to recessions. These actions could help to prevent negative shifts in the AD by stabilizing employment and the consumption and investment activities who become unemployed during the recession. The government spending and transfer payments like unemployment benefits helps to increase the AD, creates the need for busineses to hire new labour and employment goes up as well as increase the consumption through an increase of the disposable income. The expansionary fiscal policy thus shifts the AD curve to the right, pushing the economy towards producing output at the full employment level (economic boom) and increasing inflation during recessionary periods.

We can take a look at the effects in Fig 2.

c) A tax cut or tax relief leads to higher disposable income in the hands of the consumers. The long run aggregate supply curve shifts outward due to output increase. This increases the consumption level, and shifts the AD curve to the right. Due to the decrease in tax, people are more willing to work. This willingness of labour to work at existing wage shfts the AS curve outwards. This increases both the price and output level. When an unexpected event like a natural distastei, epidemic etc. causes extreme changes in the future output, and causes a dramatic shift of the AS curve, forcing prices to reach a new equilibrium level, it is known as a supply shock. It can be bothe temporary and permanent. The AS curve shifts to the left, rising prices and reducing the real output. Increasing taxes and labour wage costs can further slow down output, decline profit margins and push producers out of business. Hence, government should offer relief on tax and wage costs to protect the manufacturering firms. A permanent negative supply shock leads to a permanent fall in potential output, which will consequently result in pessimistic expectations of future income and wealth. This may cause the consumers to cut down on their expenditure and consumption. TTheir real wealth will decreases, leading to a fall in consumption. Supply shocks to lead to a period of stagflation, which exhibits stagnant economic growth, and economic conditions like high unemployment and inflation. So, government needs to carry out policies which increase the aggregate supply, increase efficiency and reduce costs of production.

We can take a look at the effects in Fig 3.

Also, I have adoined a fig 4 explaing what happens during a negative supply shock. Thank You!