Answer to Question #219466 in Microeconomics for fanscil

Question

’Many households are gloomy about the economy as a result of Covid-19, and they opt to save more.“

Identify if the above action changes/shift the aggregate supply curve in the short term or the aggregate demand curve in the short term, or even both. Use AD-AS to illustrate(draw a graph) and explain the effect of action that change/shift a curve.

Answer 1

The economy's huge lockdown reflects a significant negative demand shock. However, a boost in unemployment benefits has temporarily raised the income of certain low- and middle-income households, which could help support aggregate demand. At the same time, supply chains in a variety of industries have been impacted not only worldwide, with international trade in general suffering a significant decline, but also domestically, with many goods and services seeing price rises. Increased unemployment benefits may allow some workers to earn more money by staying at home rather than returning to work.

If the increasing supply of government bonds continues, it will have a favorable influence on the equilibrium interest rate, as long as these bonds are deemed safe. The rationale for this is that safe assets have a lower yield than bonds due to the convenience yield. The lower the convenience yield and hence the higher the equilibrium interest rate, the bigger the supply of safe assets (conditional on the demand for safe assets). Safe government bonds provide a vehicle for the private sector to store its enhanced savings in the face of a dramatic decline in aggregate demand and potentially greater precautionary saves. As a result, greater debt issuance prevents the equilibrium interest rate from decreasing beyond a certain point. During this crisis, a coordinated European debt issue (corona bonds or ESM issuance) could help meet the private sector's appetite for secure assets.

Figure 1 Supply and demand in sovereign bond markets