Answer to Question #227721 in Macroeconomics for wang

Question

a) The Covid-19 pandemic as well as Brexit has severely disrupted worldwide supply chains. This disruption has forced many domestic producers to source essential inputs from local, more expensive suppliers instead of foreign, cheaper ones.

(i) Discuss, and illustrate (using the WS-PS model and Phillips Curve model) how this supply shock is likely to impact the labour market and inflation expectations moving forward. (6)

(ii) Provide an example of a supply-side policy that you think government could pursue in an attempt to reduce these supply-side impacts from Covid and Brexit. (4)

Answer 1

i.)

Equilibrium in the labor market is shown by the following graph where x-axis depicts unemployment and y-axis is the real wages . In this graph PS relation is a horizontal line and WS relation depicts inverse relation between unemployment and real wages.

Now let the point A be the initial equilibrium point before Covid outbreak corresponding to unemployment level (u1) and and real wages set at the PS relation equivalence level (1/(1+m)

Impact of Covid outbreak in this system can be captured by the change in level of markup (m) as supply chain disruptions lead to firms charging higher prices over wages .

Due to this there is an increase in markup from (m) to (m') which leads to downward shift in PS curve and the equilibrium real wages also decline . This leads to equilibrium unemployment level to shift from point (u1) to (u2)

And Since , u2> u1 the unemployment has increased .

# Phillips Curve is the locus of points showing the inverse relationship between inflation and unemployment .

Now as from above analysis we have seen that the unemployment level has risen due to the supply chain disruptions . Hence it will lead to dis-inflation in economy , which would be demand driven as the unemployment rises the aggregate income of economy comes down which wipes off the level of demand in the economy .

ii.) 

As we have seen Supply chain disruptions had an impact on the markup(m) which forced firms to charge higher prices over wages . So the any policy which could restore this change will be required by government to be put forward .

Example :

Providing subsidies for domestic production / PLI schemes (Production link incentives ) . PLI schemes provide tax rebates to domestic producers in accordance with the level of their production . This will bring down the costs of production and domestic supplier for raw materials would be incentivezed to supply at cheaper rates due to tax rebates /subsidies .