Answer to Question #194047 in Macroeconomics for Thabiso

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

The macroeconomic models of AD-AS and IS-LM-BP deal with the macroeconomic issues and policies that result in changes in GDP level, inflation rate and interest rate.   

The Covid-19 crisis has appeared as a negative ss shock to the economy of South Africa. To overcome the situation, the government has initiated a relief program of R500bn to stimulate economic growth in the country. The following diagram illustrates the case.

In the above diagram, E* is the LR equilibrium point of the economy while E1 represents the initial equilibrium point of the economy. Corresponding to point E1, the SRAS’ curve has shifted leftwards due to negative ss shock (triggered by Covid 19) and Y1 is the initial output level which is lower than the potential output level (Y*). This suggests that the economy is initially suffering from a recessionary phase. 

As a result of this the government initiates a relief program which raises its expenditure in the economy i.e. the component G of the AD curve rises as a result of which the AD curve shifts rightward after the policy has been undertaken. As a result of this shift, the output level rises to its potential level (Y*) and the price level also rises further in the economy to P2. Thus the government policy is effective in achieving higher economic growth and recovering from the recessionary phase. 

The following diagrams illustrate the effect of the policy in the context of IS-LM-BP model. 

In the IS-LM-BP model, there are two cases - one under fixed exchange rate and another under flexible exchange rate. Under fixed exchange rate, as the government adopts expansionary fiscal policy the IS curve shifts rightwards and the intermediate equilibrium is attained at point E1. Since E1 point lies above the BP curve it implies that there is BOP surplus in the economy. Since the exchange rate is fixed, the government will intervene and buy foreign currency and sell domestic currency to correct the surplus. Thus the LM curve will shift rightwards and the final equilibrium is achieved at point E2 where the GDP level rises but the interest rate remains unchanged. Hence expansionary fiscal policy is completely effective under a fixed exchange rate scenario. 

Under flexible exchange rate, as the government adopts expansionary fiscal policy the IS curve shifts rightwards and the intermediate equilibrium is attained at point E1. Since E1 point lies above the BP curve it implies that there is BOP surplus in the economy. Now the exchange rate is not fixed, so it will lead to appreciation of domestic currency. Thus exports would drop and imports would rise. This would as the IS curve to shift leftwards to its original position. Hence new equilibrium point E2 will coincide with E0 (initial point) and the output level would not change. Thus the fiscal policy would be completely ineffective in this case. 

 

Thus it can be concluded if the government adopts expansionary fiscal policy to correct the economy under fixed exchange rate then it would be effective in raising the GDP level and the price level would also rise. The economy would be able to overcome the negative ss shock .