COVID-19 Pandemic Recession, Policy Response, and Recovery: A Canadian Perspective

The purpose of this paper is to explain the economic impact of the Covid-19 pandemic on Canada’s economy and the response by the monetary authority. We also explain a potential adjustment process on the way to recover from the pandemic recession


FIGURE 1: Pandemic Crisis and AD-AS Shock
The figure shows the initial equilibrium point E was very close to the full employment level of output before the pandemic began.Increased unemployment rate (approximately 12-15 percent) due to COVID-19 decreased a significant amount of aggregate demand from AD0 to AD1.Businesses and production units were closed due to lockdown resulting in a significant decrease in aggregate supply to AS1.Consequently, there was a pandemic recession resulting in negative output growth.In a static model, we can show the new equilibrium at point F. Since production has been interrupted significantly by the COVID-19 crisis, generally, we may expect a high rate of inflation during this period.However, the reality was different.We saw a lower level of inflation during the pandemic recession (2020-2021) in the first three-quarters of the pandemic.People might consider the low level of inflation during the pandemic crisis as a surprise.However, this is not a surprise at all.A decrease in production, a significant interruption in the supply chain, and a decrease in aggregate demand (due to job loss) cause the rate of inflation to be lower (at P1 level) due to a shift of both AD and AS.
The question is now how the economy will recover from the COVID-19 pandemic crisis.Let us consider both the fiscal and monetary policies that are taken by the Canadian government and the Bank of Canada.Figure 2 explains the policies implemented by the Canadian economy and the short-run and long-run responses to the policies.Canadian government implemented an expansionary fiscal policy i.e., the government financed the economy with a huge COVID-19 crisis recovery stimulus package of C$107 billion (March 2020) as emergency aid and economic stimulus, and $100 billion for post-pandemic recovery (December 2020).The Bank of Canada simultaneously implemented an expansionary monetary policy by lowering the policy rate to a record low of 0.25% (Bank of Canada, 2020).Due to a quick simultaneous response from both the fiscal and monetary sides, the economy has been in a recovery process for the last few quarters now. Figure 2 shows that both the IS and the LM curves shift to the right, from G which is expected to reach around equilibrium H, eventually.Due to employment insurance and the Federal and Provincial government's support to households and employees' wage support to businesses, the aggregate demand and aggregate supply have already recovered to some extent.It is expected to increase over time.The speed of adjustment to the new equilibrium H will perhaps depend on the speed to normalization of the economy and re-opening the businesses by administering the COVID-19 vaccine sooner than later.According to the Public Health Agency of Canada, approximately 67% of the total Canadian population have received at least one dose of vaccine, and 36% are fully vaccinated as of July 12, 2021.It shows that Canada is performing well in the COVID-19 vaccination program.
Inflation is not high right now.However, in the long run, wages will increase due to an increase in production.Employees will ask for their fair share in business profit which will lead to an increase in the price level.The economy will also reach its natural level of production again.Figure 3 shows a potential adjustment path for the Canadian economy post-COVID-19 pandemic crisis using the AD-AS framework.The price level is not high yet due to a simultaneous and adverse demand and supply shock.The expected price level adjustment to the long run will be upward, and the economy will recover to its natural level of output.Due to technological advancement for the economy to reach from I to J might not cost much inflation.Of course, the central bank has sufficient tools for inflation targeting too.

Conclusion:
In 2020, Canada, like many other countries, injected a lot of money into the economy to fight the economic slowdown.At the same time, the monetary authority reduced the interest rates to a record low to make borrowing easy.A potential consequence is a high rate of inflation.Besides, in a situation like this, an imbalance between demand and supply of goods and services leads the economy to a short-term disequilibrium.It takes time for the economy to adjust the supply following increased demand.Not only production, but the supply chain also matter in this circumstance.After a few uneven fluctuations, however, the economy is expected to adjust towards its natural level in terms of production, employment, supply, and demand in the long run.

FIGURE 2 :
FIGURE 2: Recovery policies and the impact (IS-LM framework)

Figure 3 :
Figure 3: Short-run to long-run dynamic adjustment path (AD-AS Framework)

FigureFigure 4
Figure3shows a potential adjustment path for the Canadian economy post-COVID-19 pandemic crisis using the AD-AS framework.The price level is not high yet due to a simultaneous and adverse demand and supply shock.The expected price level adjustment to the long run will be upward, and the economy will recover to its natural level of output.Due to technological advancement for the economy to reach from I to J might not cost much inflation.Of course, the central bank has sufficient tools for inflation targeting too.Figure4: Canadian Economic Recovery