Question

The aggregate demand/aggregate supply model is used to understand short-run fluctuations in real GDP (i.e. the business cycle). According to the aggregate demand/aggregate supply model, what are some of the things that can cause a recession? Also, discuss the relationship between the business cycle and the unemployment rate?

Answer 1

Recession is a situation where the economic activities are reduced. It generally occurs when there is a widespread decline in the spending i.e. aggregate demand declines. There could be many causes which cause a recessionary situation in the economy:

1. Higher interest rate: An increased interest rate in the economy makes borrowings costlier due to which people in the economy. Reduced borrowings leads to lower spending which further reduces the aggregate demand in the economy. This leads to recession in the economy.

2. Reduces real wages: Inflation in the market increase the price of the goods and services in the market. An increase in the price of the goods and services in the market reduces the purchasing power of the potential customers in the market. Decreased real wages leads to decrease in demand of potential customers in the market which causes recession in the economy.

3. Credit crunch in the market: A financial crunch with the banks results in the lower lending power of the banks. Lower lending power means bank will issue less loans which will decrease the purchasing power of the customers. This will cause decrease in aggregate demand and will cause recession.

Recession is a phase in which an economy moves from peak to trough condition i.e. economic activities are reduced in the economy. With decrease in aggregate demand in the economy the production in the economy falls i.e. economy produces below the production possibility curve which causes unemployment situation in the economy. When economy moves into recession period the unemployment rate in the increases and vice-versa.