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Suppose consumers and investors suddenly become more pessimistic about the future and therefore decide to reduce...

Suppose consumers and investors suddenly become more pessimistic about the future and therefore decide to reduce their consumption and investment spending. How will a market economy adjust to this increase in pessimism?

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Answer #1


Ans. Increased pessimism decreases consumption and investment spending leading to decrease in aggregate demand for goods and services this shifts the aggregate demand curve leftwards from AD to AD'. This at given aggregate supply leads to decrease in price level from P to P' and equilibrium output from Y to Y'.

In long run, this decrease in price level makes production units to revise their inflation expectations downwards leading to increase in aggregate supply shifting the aggregate supply curve from AS to AS'. This leads to an increase in equilibrium output from Y' to full employment level Y and decreases prices further to P".

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