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Lesson M12.L04: COVID-19 as a Macroeconomic Shock: Policy Response

Module: Financial Crises; Macroeconomics: What Have We Learnt? Level: intro Duration: 30 minutes Learning Objective: Apply the AD-AS model to evaluate Australia's combined fiscal and monetary response to COVID-19. Data as of: 2024 Provenance: RBA Education | OpenStax Macro 3e | LibreTexts Macroeconomics

Explanation

The COVID-19 pandemic created a macroeconomic shock unlike most others: it simultaneously hit both sides of the economy at once.

In AD-AS model terms: - Aggregate Demand (AD) fell as households stopped spending (lockdowns, fear), investment collapsed (uncertainty), and international borders closed (tourism, education exports fell to zero). - Aggregate Supply (AS) also fell as businesses closed, global supply chains fractured, and workers could not attend workplaces.

This dual supply-and-demand shock caused GDP to fall 7% in Q2 2020 — the worst single-quarter contraction since World War II.

The policy response was unprecedented in speed and scale:

Monetary policy: The RBA cut the cash rate to 0.10% (November 2020) — effectively zero. It also deployed two unconventional tools: Yield Curve Control (YCC) — targeting the 3-year Australian Government bond yield at 0.10% by buying bonds as needed to hold that target — and a Term Funding Facility providing cheap 3-year loans to banks. A separate Asset Purchase Program (bond buying in the secondary market, sometimes loosely called QE) purchased ~A$350bn in bonds to reduce longer-term yields. YCC was abandoned in November 2021 when markets tested the target; bond purchases wound down through 2022.

Fiscal policy: The Morrison government deployed approximately **A\(300bn** in total fiscal support, including: - **JobKeeper** (A\)89bn): wage subsidy program paying A\(1,500/fortnight to eligible employees to keep them attached to employers during lockdowns - **JobSeeker** supplement: doubled the unemployment benefit temporarily - **Early superannuation access**: allowed individuals to withdraw up to A\)20,000 from super (controversial — reduced retirement savings) - Infrastructure spending and business investment incentives

Australia recovered from COVID quickly: GDP returned to its pre-COVID level by mid-2021, among the fastest recoveries in the developed world. But the fiscal cost was enormous and contributed to a decade of budget deficits.

Worked Example

AD-AS analysis of the COVID shock and recovery:

Baseline (pre-COVID, FY2019): - GDP = A$2,000bn (potential output) - Price level index = 100 - Unemployment = 5.2%

Step 1 — Initial COVID shock (Q1–Q2 2020): AD falls: consumption −15%, investment −20%, net exports −30% (borders closed) Approximate total AD fall: −7% of GDP = −A\(140bn AS also shifts left (supply chain disruption, worker absence) Result: GDP = 2,000 − 140 = **A\)1,860bn** (−7%) Unemployment surges toward ~10% without policy response

Step 2 — Policy response (AD stimulus): Fiscal stimulus: JobKeeper ($89bn final audited cost; initially estimated \(70bn) + JobSeeker supplement + other = ~A\)160bn in FY2020–21 Monetary stimulus: Rate cuts lower cost of borrowing; QE flattens yield curve Combined AD boost ≈ +A$200bn (including multiplier effects)

Step 3 — Net effect on AD: AD returns to approximately: 1,860 + 200 = A$2,060bn by mid-2021 GDP exceeds pre-COVID level; unemployment falls back toward 5%

Step 4 — AD-AS diagram interpretation: The large rightward shift in AD (from policy) more than offsets the leftward AD shock. However, since AS also fell (supply-side constraints), the recovery created inflationary pressure — with both high AD and reduced AS, the economy ended up above the new short-run supply curve, contributing to the inflation surge of 2022–2023 (CPI peaked at 7.8% in December 2022).

Step 5 — Fiscal cost as % of GDP: Total fiscal cost ≈ A\(300bn FY2020–21 GDP ≈ A\)1,950bn Fiscal cost as % of GDP = 300 / 1,950 × 100 = ~15.4% of GDP — one of the largest peacetime fiscal responses in Australian history.

Common Misconception

Misconception: "The COVID fiscal response was too large and directly caused the post-2021 inflation."

Correction: The stimulus was appropriately large given the uncertainty at the time. In April 2020, the RBA and Treasury forecast unemployment could reach 15%; the aggressive response prevented that. The post-2021 inflation was primarily caused by global supply-side factors (energy prices post-Ukraine war, supply chain disruptions) rather than Australian fiscal policy alone. The RBA's 2022 modelling suggests domestic fiscal policy contributed to inflation, but global factors dominated. The harder critique is that the RBA held rates at 0.10% too long into 2021–22 as the recovery exceeded forecasts — but that is a question of monetary policy exit timing, not of the initial stimulus being wrong.

Practice Prompts

  1. Using the AD-AS model, explain why the COVID-19 shock was unusual compared to a typical demand-side recession. Draw a verbal description of the diagram. → Answer: A typical recession (e.g. from a fall in consumer confidence) involves only a leftward shift in AD — output falls and prices tend to fall or stagnate. COVID-19 was unusual because both AD and AS shifted left simultaneously: AD fell (lockdowns, fear, closed borders) AND AS fell (supply chains broke, workers couldn't attend work, businesses closed). This produces a larger fall in output than a pure demand shock. It also creates ambiguous price effects — AD down would lower prices, but AS down raises prices — contributing to the unusual "stagflation-lite" of 2021–22 as AS recovered slowly and AD was boosted by stimulus.

  2. JobKeeper paid A\(1,500 per fortnight to approximately 3.5 million eligible employees for 26 fortnights (originally). Calculate the total cost of this phase of JobKeeper. → **Answer:** Cost = 3,500,000 employees × A\)1,500/fortnight × 26 fortnights = 3,500,000 × 1,500 × 26 = 3,500,000 × 39,000 = A\(136,500,000,000 = approximately A\)136.5bn Note: The actual cost was A\(89bn because not all recipients received the full duration, the payment rate changed (A\)1,200 and A$750 tiers were introduced), and some recipients were later found ineligible (leading to repayments). The calculation shows how a seemingly small per-person payment at scale becomes a very large fiscal commitment.

  3. Why did Australia's rapid recovery from COVID-19 (back to pre-COVID GDP by mid-2021) create macroeconomic challenges in 2022–2023? → Answer: The rapid recovery created excess demand relative to supply capacity. Key channels: (1) Households had accumulated large savings buffers (from stimulus + restricted spending during lockdowns) and unleashed a spending surge in 2021–22; (2) Supply chains remained disrupted globally, so increased demand met constrained supply — raising prices; (3) The RBA had committed to keeping rates at 0.10% until 2024 (forward guidance it later had to abandon); (4) The global energy price shock from the Russia-Ukraine war (2022) added further inflationary pressure. The result was CPI reaching 7.8% by end-2022, forcing the RBA to raise rates 13 times in 18 months — illustrating how successful short-run stimulus can create medium-run inflation management challenges.

Further Resources