Question

Propose a factor that captures the effect of a financial shock (e.g., the subprime crisis) as a leftward
shift of the Aggregate Demand in the P-Y space.
You should clearly state the factor, how the factor changes (increase or decrease) and explain how it
shifts the Aggregate Demand Curve to the left in the P-Y space.

Answer 1

An example would be the recent COVID pandemic that's ravaging all over the world.

Due to the emergence of COVID 19, the government has announced lockdown to curb spreading of the virus. The industries have been shut down, leading to less output production. The consumers are spending less and demanding less because most of them are now unemployed due to the lockdown. As the production has gone downhill, industries need less workers to sustain them. As a result, lots of workers are laid off. So, consumption demand is lesser due to the crisis.

Due to this crisis, investors are skeptical about investing in any new projects because they are not sure how it will perform. Hence, investment demand falls.

Now aggregate demand in the economy is a sum of consumption demand and investment demand alongwith mainly. So when the two major constituents fall, the aggregate demand in the economy will inevitably fall.

Now, if we can explain it in terms of AD curve, we can say the following:

Due to the pandemic, at every level of prices and outputs, consumers and investors are demanding less. Thus at every level of price and output, the aggregate demand is lower than what it was before.

Hence, the aggregate demand curve shifts parallely leftwards (in the P-Y space) with regards to increase in the COVID crisis all over the world.

......

Hope you get the idea!