Answer to Question #192485 in Macroeconomics for Koketso Makua

Question

The Covid-19 crisis and lockdown has been a supply-side shock to the South African economy. In response, the government offered a R500bn stimulus package to help cushion the blow. Use the AD-AS model, in conjunction with the IS-LM-BP, to explain the supply and demand dynamics of the shock and policy response. Where will equilibrium income and prices settle?

Answer 1

Whenever there will be a shock in supply side. As will go up to AS2, again after intervention through policy and after that it will again comeback to the original portion.

 Hence, our initial position in AD-AS model is A which is same in IS-LM-BP model as £, in this place there is no shock or the shock is O, after getting shock the points have been changed as the supply got affected, hence the supply got shipped to AS2, As O, the point B got changed with the price change from P₂ to P1, along with that income output decreases from Y1 to Y2.

In the same flow IS-LM-BP also got affected as the initial equilibrium point E and after change in the supply, the IS curve will shift to leftwards at the new equilibrium point F: with low interest rate & low income.

Now, when government offer a stimulus package of 500 billion to push the economy. In that case, the economy will again pull the As curve back to the original position and then there will be restore of price, interest sale & Income which will be back to the original position.

Now, to avoid the complexity of the diagram, here we assume that the restoration is exactly the loss amount. Although in reality it is less than the original one.