In our previous post, we documented the changes in the “big three” macroeconomic variables—the unemployment rate, the inflation rate, and the real GDP growth rate—in Australia, Canada, the U.K., and the U.S. at the beginning of the COVID-19 pandemic. But macroeconomics is more than simply measuring variables. In this post, we use the AS–AD model to understand these macroeconomic phenomena.
What is the AS–AD model?
The aggregate supply–aggregate demand model (AS–AD model) is a macroeconomic model that uses similar ideas to the demand-supply model that determines a market price and quantity. But the aggregate supply–aggregate demand model isn’t just an application of the competitive market model: It’s a model of an imaginary market for real GDP. The quantity in this “market” is real GDP and the price is the price level.
What happened to short-run aggregate supply?
The story of COVID-19 and aggregate supply is a story of employment. Stay-at-home orders and social distancing rules in various countries included closing down transport, bars and restaurants, gyms, hairdresser and barber shops, and non-essential retail. The world’s lockdowns decreased employment. Short-run aggregate supply decreased.
What happened to aggregate demand?
As the pandemic dominated the globe, consumption expenditure decreased substantially. Countries also saw decreases in investment. Initially, aggregate demand decreased sharply.
To stimulate economic activity, governments increased transfer payments to protect jobs and keep businesses investing. Central banks slashed interest rates and injected money to enable commercial banks to make loans to cash-strapped households and firms. These effects worked against the initial reductions in aggregate demand, but did not restore aggregate demand to its pre-pandemic levels. The combined effect decreased aggregate demand.
What happened to real GDP?
Short-run aggregate supply and aggregate demand decreased. In the new short-run macroeconomic equilibrium, real GDP decreased.
What happened to the price level?
When short-run aggregate supply and aggregate demand decrease, the price level can rise, fall, or remain unchanged. Because the decreases in short-run aggregate supply and aggregate demand were similar in magnitude, the price level remained unchanged.
What happened to unemployment?
Assuming the output gap was close to zero in 2019, the economy was at full employment before the pandemic hit. When short-run aggregate supply and aggregate demand decreased, a new short-run macroeconomic equilibrium emerged in which potential GDP exceeded real GDP—a below full-employment equilibrium. Unemployment increased.
Let’s look at the macroeconomy during the COVID-19 pandemic.
Multiple Choice Test: Putting the Macro Pieces Together