Impact of COVID-19 on Indian Economy

Using a Macroeconomic Approach: an IS-LM framework

Image Source: ET Government

COVID 19: A virus of the size of 0.12 microns has not only led to more than 600,000 casualties, but has also crippled the global economy and stalled economic activity across the world. This being said, if we focus on India, we see that the economic situation is no better. As said by the RBI Governor on 21 May 2020, GDP growth in 2020–21 is likely to go negative. In this blog, I analyze the impact of COVID19 on the Indian economy through an ISLM Framework.

GDP growth in 2020–21 likely to go negative, says RBI Governor

In his address on 22 May, the RBI Governor said, ‘The biggest blow is to private consumption that accounts for 60% of domestic demand’.

The implications of this statement will become clear through this analysis.

You might be wondering what an IS-LM framework is. So, before you read on, I define IS and LM models here:

• IS Curve (Investment -Saving Curve): The IS curve shows combinations of interest rates and levels of output such that planned spending equals income.
• LM Curve (Liquidity and Money Market Curve): The LM curve shows combinations of interest rates and levels of output such that money demand equals money supply maintaining the equilibrium in the money market
• IS-LM Curves: The IS and LM schedules summarize the conditions that have to be satisfied in order for the goods and money markets, respectively, to be in equilibrium.

The IS-LM model is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the assets/loanable funds market (LM) or money market. In a way, the IS Curve represents the Goods market and the LM curve the Money market. If you’ve not understood this yet, don’t worry, it’ll become clear as you read on.

1. The IS CURVE (Goods market)

Let us first analyze the IS Curve. We know that people are buying much less than otherwise, and their purchasing power has decreased during the lockdown in India. The demand has decreased, which means that the Aggregate Demand(AG) has decreased. We are not spending on anything much except essential goods. So, the Autonomous Spending( ͞͞A, independent of the level of income, hence autonomous) has decreased.

Without going into the mathematical details, assume that Consumption is given by C= C’+c (TR’)+c(1-t)Y

Where ,

c= MPC(Marginal propensity to consume),

C’= Autonomous Consumption,

Y=income

TR’=Transfers

tY= Taxes

The RBI Statement given in the abstract mentions that consumption has received the biggest blow. This private consumption(C) includes the household consumption of goods and services. It accounts for nearly 60% of the domestic demand. So, a decrease in private consumption is one of the factors that have caused a decrease in Autonomous Spending(͞ ͞A), as shown by the formula of ͞͞A in the following text.

• Investment, I= I’-bi , where, I’= Autonomous Investment, i=Interest Rate
• G= Government Spending
• NX=Net Exports (=Exports-Imports)

From the above equations and from AD= C+I+G+NX, we find:

Hence, during COVID19, Autonomous Spending has decreased which has led to a decreased Aggregate Demand (since AD is a function of ͞͞A). Also, from the above equation of the IS Curve, it is seen that the decrease in Aggregate Demand leads to a decrease in Income(Y) and a decrease (leftward shift) in the IS Curve at the same interest rate(i). So, the IS Curve shifts downwards and leftwards.

2. The LM CURVE (Money market)

The LM Curve is given by this equation:

In the COVID19 Scenario, the Money Supply has not changed, as there is no change in the monetary supply by RBI. But Money Demand has decreased.

The LM curve shows the combination of interest rates and levels of output when money demand is equal to the money supply. To counter affect the decrease in money demand, it has to be increased by reducing the interest rates. And as we know, the interest rates have really been decreased. Also, note that the income(Y) has also decreased. Both these decrease in a manner that the LM Curve doesn’t shift.

3. The Combined IS-LM Framework

When we combine the above 2 curves for the COVID19 situation, to bring the goods and money market in equilibrium (the IS-LM framework), we see the following graph in which:

• IS Curve has shifted leftwards. A decrease in autonomous spending shifts the IS curve to the left
• LM Curve has remained unshifted

This is the IS-LM framework for Analysis of COVID19:

The graph shows that: ‘i’ decreases, ‘Y’ decreases, and a new equilibrium is established(the ‘new’ normal)

This model and the above graph show the impact of COVID19 on Indian Economy:

• the National Income(Y) decreases, which means a decrease in GDP.
• Also, there is a decrease in the interest rate, since the RBI has been cutting the interest rate for a while now.
• The new equilibrium includes a decreased interest rate and a decreased national Income which directly relates to GDP
• The IS-LM Curve also shows that the change in the IS curve is more than the change in Income(Y) because of the slope of the LM curve. This highlights a non-expansionary fiscal policy wherein government spending/investment decreases.

The Indian Economy is facing a huge negative impact due to Covid19. The above model somewhat gives us an insight into this. In fact, the World Bank, on June 8, 2020 said about the Covid-19 impact on Indian economy: India’s economy is expected to shrink by 3.2% in FY21.

Amidst all this, the recent ₹ 20 lakh crore economic stimulus package released by the Finance Minister Nirmala Sitharaman, which includes ₹ 8.01 lakh crore of liquidity measures announced by the Reserve Bank, is sought to bring some relief to the economy.

Let’s hope this effort by the government and the RBI is implemented properly and the Indian Economy gets the much-needed impetus.

All views expressed are my own. Feedback/suggestions welcome at ashwingoyal154@gmail.com

References:

1. The Hindu
2. Rudiger Dornbusch, Stanley Fischer, Richard Startz — Macroeconomics
3. RBI Report
4. Business Standard
5. The Economic Times