Question

It is hard to escape the daily barrage of news regarding the COVID-19 pandemic! Economies around the world are struggling on many fronts. Production is declining while financial markets appear to be reaching new lows every day. This discussion is meant to check your knowledge of the Keynesian view of how an economy functions. Specifically, I would like you to answer the following questions. You can go beyond answering these questions, but please do so only after you have made sure that you have covered the following questions:

• Discuss at least two channels through which the pandemic appears to affect the economy. Make sure that you do not refer only to the decline in prices of financial assets but to how the pandemic affects production or GDP. For example, how the shock of the pandemic is likely to play out in the Keynesian cross? Hint: think about the impact on aggregate demand components!
• Discuss the effect of the shock on the interest rate, or bond yields. Further, how does the change in the bond yields is likely to affect the real side of the economy? Hint: first what does appear to be happening to the interest rate; what effect should the change in the interest rate have on investment? Do you think that investment will respond to the change in the interest rate as predicted by the theory?
• Think now about macroeconomic policy! How do you think policymakers will or are reacting? What kind of policies are they likely to put in place? Hint: think of monetary and fiscal policy, and think in terms of the policy tools for each. What are the channels through which these policies will affect the macroeconomy Hint: for example, think of the likely change in government spending (in which direction?). What impact will it have on aggregate expenditure, leading to what impact on inventories etc. You can also elaborate your answers using references to the Keynesian cross and Money market graph (if you are explaining the effect of monetary policy) following a policy intervention i.e. which curves shift and in which direction.
• Which policy (monetary or fiscal) do you think will be more effective in the current situation? Explain your answer.

Answer 1

Economies around the world are affected by the outbreak of coronavirus disease. COVID-19 has been declared a Public Health Emergency of International Concern by the World Health Organisation. It was first identified in Wuhan, Hubei, China in December 2019.

The virus spreads via respiratory droplets from coughing or sneezing. There is currently no vaccine or specific antiviral treatment. Efforts are aimed at preventive measures that include handwashing, maintaining distance from other people (particularly those who are sick).

The wider impact of the outbreak has included social and economic instability. Global supply shock and Global demand shock by the coronavirus outbreak affects production or GDP. This happens because everyone simply stays at home. With shortages of everything from auto-parts to generic medicines and production delays in things like iPhones and Diet Coke. The fundamental reason is economic structure that is when people pull back from interacting with others because of their fear of disease has a very big impact on industries. Traveling, attending sports tournaments, joining gyms are some of the examples of the slowdown of economic activities.

Keynes' law states that demand creates its own supply; changes in aggregate demand cause changes in real GDP and employment. The Keynesian zone occurs at low levels of output on the SRAS curve where it is fairly flat, so movements in AD will affect the output but have little impact on the price level.

There is a leftward shift of AD curve due to the outbreak of deadly coronavirus. This shift will result in a fall in production or GDP. Though Keynesian cross suggests that the price level will stay the same but in reality, there may be a significant decline in expected inflation due to reduced consumer demand.

Now, let's consider the effect of the shock on the interest rate or bond yield. After the string of deaths, some heart-stopping plunges in the stock market and an emergency rate cut by the Federal Reserve show the economic impact of the virus. Due to damage, Central banks and financial analysts are talking about a global recession in the coming months. The stock market turmoil has gotten the most attention, these ultra-low yields on safe, long-term bonds are a warning light that the coronavirus situation is likely to have a serious, negative, and persistent effect on the economy.

Tim Duy, an economics professor at the University of Oregon, offers a less alarming explanation for interest rate move: Falling long term interest rates will cause mortgage rates to fall. This is good news for home buyers, but it means banks have to be prepared for existing borrowers to pay off their mortgages and refinance at lower rates. This can lead to a self-enforcing cycle: Long term rates are falling, so banks need to buy long-term bonds, which bids up their price and causes long-term rates to fall even more. (bond prices go up when bond yield go down)

"I'm an optimist", says Duy, and thinks it is possible to avoid a coronavirus related recession. If we do have a recession, he expects it to be a mild one along the lines of the recession in 1990-91, not a 2008-style crisis.

Still, Duy acknowledges other possible explanations for the fall in the interest rate that are more alarming: that they are a sign that investors expect a slower and more prolonged recovery from a recession that may involve extended shutdowns of commerce around the world; or that they reflect an overall worsening of economic expectations that have not yet fully priced into the stock market, which rose slightly recently even as bond yields continued to fall.

So, it is likely that the investment will respond to the change in the interest rate as predicted by the theory.