2. Keynesian Paradoxes at the ZLB in a Pandemic: Consider the IS/LM and AD/AS model we constructed in week 8's lecture and drawn below (Figure 1). Assume in the short run that the price level is perfectly fixed but wages are perfectly flexible. The red line shows the maximum employment that can occur under social distancing rules. The blue line shows the Page 1 of 3 Figure 1: Question 2: Keynesian Paradoxes at the ZLB in a Pandemic W/P Social distancing employment limit Wo/P* ro * Ld IS Yo F(K,AL) P LRAS vo SRAS AD Yo YNFigure 1: Question 2: Keynesian Paradoxes at the ZLB in a Pandemic W/P Social distancing employment limit LM Wo/P* ro Ld IS Yo Y F(K,AL) LRAS Yo SRA AD Yo YN effective demand for the goods produced and how much labour is required to produce that amount. Analyze the following scenarios by describing the short run impact on output (y), real wages (W/ P), and the real rate of interest (r): (a) Analyze the effect of everyone deciding to save more now and in the future, i.e. of falls (paradox of thrift). (b) Analyze the effect of an increase in people's willingness to supply labour by studying a rightward shift of the labour supply curve. Assume that the increase in labour supply also lowers inflation expectations (paradox of toil). (c) Given the assumptions made, can government spending completely offset the effects of the pandemic? What if social distancing is removed? (d) Assume the government ends social distancing but refuses to do any more fiscal stimulus. Furthermore, assume that price level slowly falls (SRAS moves down) when y is below y,, the LRAS. Under these assumptions with a binding zero lower bound, will the economy return to yn on its own? Explain (hint: think about the effect of a fall in the price level on inflation and expected inflation.)