Question

Suppose the world is experiencing a pandemic and the economy is experiencing both a severe short- run supply-side shock as people must stay away from work to prevent the spread, but also a decrease in the demand for goods and services that pushes the economy into recession. Based on the models provided in our class, what do you expect to happen to the economy? Illustrate your answer with the AD/AS graph and ISLM. Note that the goal of this question is to demonstrate mastery of the models and graphing skills and not to provide the most accurate predictions. Provide the results from the models even if you are not comfortable with the result. Do point out any potential ambiguities that develop within the model. Report as many economic measures as you are able given the models.

If the government does nothing, what ensures that the economy still eventually gets back to the natural rate of output? Explain and illustrate your answer with a graph(s). Given the Classical versus Keynesian debate, which do you think will be more useful in the current pandemic and why?

If the government wanted to fight this recession, what tools do they have available and how should the use them? Explain fully and illustrate your answer with a graph. Be sure to explain what will happen to the price level and real GDP as we return to normal.

Answer 1

Answer-

AD/AS, known as aggregate demand-aggregate supply model is the fundamental tool in economics. It is represented by a graph for all factors of the economic framework of an economy. It represents changes in national income and the price level. We can use this to illustrate phases of the business cycle and the impact of different events on GDP also known as real GDP and inflation. Further, the AD/AS framework also accommodates both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

The AD/AS curve are represented as follows in Graph

Axes X – Price Level is represented as PL on Vertical axis

Axes Y – Horizontal axis represents GDP known as Real GDP.

A downward sloping AD aggregate demand curve is labeled as “AD.” In the graph and upward sloping for short-run known as aggregate supply curve is labeled as “SRAS.”

Figure -1

Figure-2

While representing an equilibrium price level and real GDP it is represented as below showing the Equilibrium. Figure -3

The aggregate supply curve is represented as vertical long-run curve of aggregate supply curve labeled “LRAS.” The LRAS is represented as vertical at the full employment output. basis the economy as an output gap or as in long-run equilibrium.

Like considering the current economic situation of the economy we will represent the Recession as in Figure - 4

Since the economy is in recession, it is represented as Y_1Y1​Y, start subscript, 1, hence end subscript representing current output and Y_fYf​Y, start subscript, f, end subscript is representing full employment.

As its recession time due to COVID-19 pandemic it is represented as Y_1Y1​Y- start subscript, 1, and end subscript is less than Y_fYf​Y, start subscript, f, end subscript.

Figure-5

The Investment Savings-Liquidity preference Money supply termed as IS-LM model focuses on the equilibrium of the market for all goods and services, and the money market. It represents the relationship between real output and interest rates.

Looking at the current economic scenarios of the global economy under impact of COVID -19 pandemic we should represent same as closed economy. Hence in a closed economy, the equilibrium condition in the market for goods is that production (Y), is equal to the demand for goods, which is the sum of investment and consumptions. This relationship is called IS and hence consumption is represented as (C)

C = C(Y-T)

where T is equal to taxes, hence the equilibrium is represented as

Y = C (Y- T) + I + G

Thus, in current economic scenario of 2020 we will see that the investment is not constant, and hence we see that it depends mainly on two factors: -

• the level of sales and
• Interest rates.

If the sales of a firm increase, it will need to invest in new production plants to increase production. The relationship is seen as proportionately equal as a positive relationship. So, if interest rates are higher the investments become more expensive and the relationship is represented as negative. Interest rate is represented as “i” in the equation

Y = C (Y- T) + I (Y, i) + G

Figure-6

​​​​​​​

The IS curve is represented by equivalence between production and demand, determines the equilibrium in the market for goods, and the impact on the interest rates. Thus, the curve represents the value of equilibrium for any interest rate.

Hence an increasing interest rate will cause a reduction in production through its effect on investment., henceforth the curve has a negative slope. Therefore, pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

The AD-AS framework shows us two ways which may give rise to inflationary pressures. Firstly, when aggregate demand continues to shift to the right when the economy is already at or near potential GDP, secondly during full employment, pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve.