Question

Using Aggregate Demand and Supply analysis supported by a diagram, show the effect on an economy of a fall in investment and explain how and in what ways government action as recommended by the OECD might stop economies falling into a recession.

Word Limit: 200 words

Answer 1

Aggregate Demand(AD) tells the quantity of goods and services demanded in an economy at a given price level.

AD = C + I + G + NX

Where, C= Consumption, I = Investment, G=Government Spending & NX = Net exports.

Investment is the part of current output devoted to further production, i.e. the creation of capital and the cost of maintaining existing capital. Fall in investment in an economy can be witnessed due to rise in interest rates, high risk and uncertainty, rise in corporate taxes, loss of business confidence, etc.

Effect on an economy of a fall in investment: Fall in investment in an economy will lead to fall in economy. Strength of any economy can be measured by two of its components:

• Aggregate demand (AD)
• Aggregate supply (AS)

A fall in investment will lead to an inwards shift of the AD curve from AD1 to AD2 (refer figure). Due to this, equilibrium point will also shift from E1 to E2. It can be clearly seen from above figure that output of economy will decrease. Due to this if we assume that supply remains AS1, market will push prices to come down. This situation cause rise in unemployment rate, further worsen the economy condition by reducing consumer expenditure. Reduction in consumer expenditure further reduces AD.

Government action to stop economies falling into a recession: OECD provides recommendations how government response should be to stop economies falling into recession. Following are the recommendations:

1. Supporting Banks by risk fencing i.e. separated their bad loan from bank record. Raising liquidity issues of banks, nationalization of banks, etc.
2. Changing monetary policy by cutting interest rates to raise investment for boosting supply and raise consumption to boost demand.
3. Reducing income tax as well as corporate tax to increase AD as well as AS.
4. Raising fiscal deficit target so as government spending can be raised to improve economy and fight with recession.