COVID-19 Update: Applying the AD and AS Analysis

Supports:  Hubbard/O’Brien, Chapter 23, Aggregate Demand and Aggregate Supply Analysis; Macroeconomics Chapter 13; Essentials of Economics Chapter 15.

Apply the Concept: Using the Aggregate Demand and Aggregate Supply Model to Analyze the Coronavirus Pandemic

Here’s the key point:   The coronavirus caused large shifts in short-run aggregate supply and in aggregate demand, so this virus caused by far the largest decline in real GDP and largest increase in unemployment over such a brief period in U.S. history.

In early 2020, the United States experienced an epidemic from a novel coronavirus that causes the disease Covid-19. We can use the aggregate demand and aggregate supply model to analyze some of the key macroeconomic effects on the U.S. economy from this epidemic. As we’ve seen, economists distinguish between recessions caused by an aggregate supply shock, such as an unexpected increase in oil prices, or an aggregate demand shock, such as a decline in spending on new houses.  The effects of the coronavirus combined both an aggregate supply shock and an aggregate demand shock.

 To this point, we have discussed negative aggregate supply shocks that shift only the short-run aggregate supply curve to the left, leaving the aggregate demand curve unaffected. It’s usually reasonable to assume that the aggregate demand curve doesn’t shift when analyzing the effects of the two main types of supply shocks: (1) a supply shock caused by an increase in the cost of producing goods and services; or (2) a supply shock that reduces the capacity of firms to produce goods and services.

            An example of the first type of supply shock is an increase in oil prices. Higher oil prices increase the cost of producing many goods and services, shifting the short-run aggregate supply curve to the left. (See panel (a) of Figure 23.7 in the Hubbard and O’Brien 8th edition text). Total spending in the economy declines, which we show as a movement along the aggregate demand curve (not as a shift in the aggregate demand curve).  That movement is the result of the higher price level reducing the spending of households and firms on consumption, investment, and net exports.

The second type of supply shock reduces the capacity of firms and is typically the result of a natural disaster such as the Tohoku earthquake that Japan experienced in 2011. The earthquake triggered a tsunami that disabled the nuclear power plant in the city of Fukushima. The disruption in the power supply to several cities, including Tokyo took months to resolve. During this period, the ability of many Japanese firms to produce goods and services was reduced, causing the short-run aggregate supply curve to shift to the left. Notice that a natural disaster will also have some effect on aggregate demand if there are deaths (about 16,000 people in Japan died as a result of the Tohoku earthquake and tsunami) or if some firms are physically destroyed, making their workers unemployed, thereby reducing the workers’ incomes and their consumption spending.  But because the resulting shift of the aggregate demand curve is likely to be small relative to the shift in the short-run aggregate supply curve, it makes sense to concentrate on the effects of the shift in short-run aggregate supply.

The coronavirus pandemic was an unprecedented supply shock to the U.S. economy. The virus originated in the city of Wuhan in China. A number of U.S. firms rely on Chinese suppliers in the Wuhan area.  In January 2020, as the government of China closed factories in that area to control the spread of the virus, some U.S. firms, including Apple and Nike, announced that they would be unable to meet their production goals because some of their suppliers had shut down. By March, as the virus began to become widespread in the United States, governors in a number of states ordered all non-essential firms to close. 

The following figure illustrates the effects of the virus on U.S. real GDP and the price level. In the figure, at the beginning of 2020, the economy was in long-run macroeconomic equilibrium, with the short-run aggregate supply curve, SRAS1, intersecting the aggregate demand curve, AD1, at point A on the long-run aggregate supply curve, LRAS. Equilibrium occurred at real GDP of $19.2 trillion and a price level of 113. By disrupting the global supply chains of U.S. firms and by leading governments to order the closure of many businesses, the virus caused the short-run aggregate supply curve to shift to the left from SRAS1 to SRAS2. (Note that in the following discussion, we are using the basic aggregate demand and aggregate supply model. In this model, there is no economic growth, so the long-run aggregate supply curve (LRAS) doesn’t shift.)

If the virus had caused a supply shock of the first type that we described earlier—affecting the economy in a way similar to a large increase in oil prices—the new short-run equilibrium would have occurred at point B.  Real GDP would have declined from $19.2 trillion to Y2 and the price level would have risen from 113 to P2. (We prepared this content and graph in early April, so we don’t yet know the full effects of the virus on the economy.  We therefore don’t attempt to put actual values on the new short-run equilibrium real GDP and price level.)

            But point B was not the new short-run equilibrium for several reasons: 

  1. Reduced consumption spending  The government closed many businesses, directly reducing output resulting in millions of workers losing their jobs. As workers experienced falling incomes, they reduced their consumption spending.
  2. Reduced investment spending  Many residential and business construction projects had to be suspended, reducing investment spending.
  3. Reduced exports  U.S. exports declined because the pandemic also led to closures of businesses in Europe, Canada, Japan, and other U.S. trading partners.

As a result of these factors, the United States experienced a sharp decline in total spending in the economy, shifting the aggregate demand curve to the left from AD1 to AD2. In analyzing the supply shock resulting from the coronavirus, we have to include the effect on aggregate demand, which we ignore when considering supply shocks caused by higher oil prices or by a natural disaster, such as an earthquake.

            Because the coronavirus pandemic caused both the SRAS and the AD curves to shift to the left, the new short-run equilibrium occurred at point C, with real GDP having fallen to Y3 and the price level having declined to P3. Note that if the shift of the SRAS curve had been larger than the shift of the AD curve, real GDP would have fallen further and the price level would have risen, rather than fallen.

            The coronavirus pandemic resulted in very large shifts in short-run aggregate supply and in aggregate demand, so this virus caused by far the largest decline in real GDP and largest increase in unemployment over such a brief period in the history of the United States.   The U.S. economy also suffered a large decline in real GDP and a substantial increase in unemployment during the Great Depression of the 1930s. But the decline in the U.S. economy during that economic contraction had been stretched out over the period from August 1929 to March 1933, rather than happening suddenly as was true with the contraction caused by the coronavirus.

Sources: Ruth Simon and Austen Hufford, “Not Just Nike and Apple: Small U.S. Firms Disrupted by Coronavirus,” Wall Street Journal, February 21, 2020; Eric Morath, Jon Hilsenrath, and Sarah Chaney, “Record 3.28 Million File for U.S. Jobless Benefits,” Wall Street Journal, March 26, 2020; and “158 Million Americans Told to Stay Home, but Trump Pledges to Keep It Short,” New York Times, March 26, 2020.

           

Question 

During the spring of 2020, many state and local governments ordered most non-essential businesses to close. Suppose that, as a result, the short-run aggregate supply curve, SRAS, shifted to the left by more than did the aggregate demand curve, AD. On the graph shown here, draw in a new SRAS given this assumption. Label this curve SRAS3. Label the new equilibrium level of real GDP Y4 and the new equilibrium price level P4. Briefly explain the relationship between Y3 and Y4 and between P3 and P4, as shown in your graph. 

Instructors can access the answers to these questions by emailing Pearson at christopher.dejohn@pearson.com and stating your name, affiliation, school email address, course number.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s