Question

Show on graph (using the aggregate demand and aggregate supply model) the effects of: A decrease in aggregate demand/recession (show what happens both in the short run and in the long run and make sure you explain your results)

Answer 1

Recession decreases aggregate demand. This shifts AD leftwards to AD'. New equilibrium is reached at es. This is a short run equilibrium where price is lower at P2 and output is below full employment level at Y'.

In long run aggregate supply changes. When output is below full employment level number of workers demanded is less which implies that wage offered is lower. This leads to reduction in cost of production which further leads to increase in supply. This shifts AS rightwards to AS' . New equilibrium is reached at eL. This results in increasing output back to full employment level, Y* and decreasing price from P2 to P3.