Question

How does a contraction in aggregate demand affect consumption, investment , taxes and money demand in the short-run and long run. How does the economy return to equilibrium?.

Answer 1

Answer - The contraction in aggregate demand takes place when there is lesser amout of money in the economy. The income levels of public fall. This leads to the decrease in its components. The consumption , investment , taxes fall in the economy due to reduced income. Since these factors decrease , the demand for money also decreases in the economy leading to phase of recession.

To combat this situation , various expansionary monetary and fiscal policies are inacted by the fed as well as government in order to increase the supply of money in the economy and to raise the income through increased employment . This gives boost to AD and the equilibrium is achieved.