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Using an AD/AS graph show that an economy can recover from a recession without increasing the...

Using an AD/AS graph show that an economy can recover from a recession without increasing the money supply and/or government spending.

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Answer #1

In the Graph shown above, the economy is at point A, the output is at Y1 and the price is P1. The equilibrium is less than the potential output and the economy is experiencing a recession.

From this point, the unemployment in the economy will be high because of less output. High unemployment will lead to a fall in the wages and that will act as a positive supply shock in the economy. It will shift the SRAS to SRAS2 and the price will be decreased. At a lower price, the output will increase and the new equilibrium will be at point B. Which is also the potential level of output.

Without government intervention, the economy will come back at the equilibrium at a lower price and higher output.

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