Answer to Question #192810 in Macroeconomics for jobe

Question

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

This will be explained through the present example: 

The lockdown due to Covid-19 Crisis has been a supply-side shock for the economy of South Africa, hence the government has offered an R500 billion stimulus package to help the country.

To avoid complexity, here in the figure below, we assume the initial points as AD, AS1, and AS2.

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

Hence, our initial position in the AD-AS model is A which is the same in the IS-LM-BP model as £, in this place there is no shock or the shock is O, after getting shocked 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 a change in the supply, the IS curve will shift leftwards at the new equilibrium point F: with low-interest rate & low income.

Now, when the government offers 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 a 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.