Question

1.) Show on a graph (using the aggregate demand and aggregate supply model) the effects of:

a.) A decrease in aggregate demand/recession (show what happens both in the short-run and in the long-run and make sure to explain your results)

b.) Expansionary fiscal policy (meaning reduction in taxes or increase in government spending) trying to stimulate the economy to get it out of the recession.

Answer 1

a) Decrease in aggregate demand or recession - In this situation, consumer income decreases due to decrease in labour prices, it will increases the problem of unemployment in the short run which put negative effect on the economy. In the long run, due to the problem of unemployment, aggregate supply curve shift rightward, which increase the output more than the equilibrium level, which causes the problem of overstock in country, due to this economic growth of country decreases, income of residents of country also decreases. So it may reduces the whole sector growth for the long period of time.

b- For solving this problem, government should frame expansionery fiscal policy i.e. reduction in taxes or increase in government expenditure which increase the income of residents by increasing investment in country. It leads to expansion in economic activities of country, which will increase the demand of labour, so the labour prices will increases, which provides direct benefit to the labour for increase their income and solving the problem of recession from country.