Question

In: Economics

Use the AD-AS diagram to show the impact of the COVID-19 virus epidemic on the Canadian...

Use the AD-AS diagram to show the impact of the COVID-19 virus epidemic on the Canadian economy in the short run and the medium run. What type of policies (fiscal/monetary) can help the economy in the short run? Show on the diagram.

Solutions

Expert Solution

The COVID-19 virus epidemic will lower consumer confidence index (which will reduce consumption) and also lower business investment confidence index (which will reduce investment). Therefore aggregate demand will fall, shifting AD curve leftward and lowering both price level and real GDP, leading to a recessionary gap in short run.

In the medium run (in absence of intervention), lower price level will reduce prices of inputs, which increases production, increasing aggregate supply. SRAS curve shifts rightward, intersecting new AD curve at further lower price level and real GDP rises to the potential GDP. Recessionary gap is eliminated.

In short run, government can implement expansionary fiscal policy (by raising government spending or lowering tax) to boost aggregate demand. Central bank can use expansionary monetary policy (using open market purchase of bonds or lower required reserve ratio or lower discount rate) to increase money supply and thus, decrease interest rate, which boosts investment demand and increases aggregate demand, restoring long-run equilibrium at initial price level and real GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. When aggregate demand decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. Short-run Recessionary gap is shown by (Y0 - Y1).

In medium run (in absence of intervention), SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

With intervention by government/central bank, AD1 shifts right to AD0, restoring initial long run equilibrium at point A.


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