Question

As businesses reopen after the shut down response to the Covid virus, the unemployment rate is exceptionally high and the economy is likely producing far below its potential. Identify a policy that may help lift the economy out of this slump. Present an analysis where you explain the impact you expect from your policy on output, prices, wages, employment, and unemployment. When analysis is warranted, more credit will be given for answers that use the diagrams presented in class. More credit will also be given for answers that include a “story” providing an intuitive explanation of the situation.

Answer 1

Ans. Due to COVID-19, output has fell from full employment level Y to Y’ and prices have decreased to P’ from P. A fiscal expansionary policy is required to increase the output. A fiscal expansion will increase government expenditure leading to an increase in spending which will increase aggregate demand shifting the curve rightwards from AD’ to AD which at given aggregate supply will lead to a situation of excess demand in the economy driving prices upwards from P’ to P. Due to these increased prices, qantity of goods supplied will increase increasing the output level back to full employment, Y. Now, as prices have increased, so, labour demand will increase, increasing the wages rate and reducing the unemployment to the natural rate.

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