Answer to Question #193022 in Macroeconomics for Kebalepile

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? Draw the graphs and explain the complete chain reaction.

Answer 1

The required graph is as follows:

Explanation for the graph:

The two models, AD-AS model and IS-LM-BP models are taken into consideration simultaneously. In the AD-AS model, the output is taken on Y axis and price is taken on the X- axis. We can see that AD curve is downward sloping and AS1 curve is upward sloping. Their intersection gives the point of equilibrium A. It is given in the question that due to the supply side shock, the economy undergoes some changes. The supply side shock shifts the AS1 to AS2. The new point of equilibrium is achieved as point B. The price rises in the economy from P1 to P2 and the output falls from Y1 to Y2.

Simultaneously, we can trace the changes in the IS_LM-BP model where output is taken on Y axis and interest rate is taken on X axis. Due to a reduction in aggregate supply in the economy, the IS curve shifts from IS1 to IS2. The BP curve also shifts from BP1 to BP2. A new equilibrium point is achieved as point F, where the interest rate is lower than before. 

When the government offers a R500bn package in the economy, the effect of the supply shock is reversed. The AS shifts back to its original position, causing, IS and BP curves to return to their original position. This leads to restoration of initial output and price levels in the economy.