Question

As an economic advisor, you are worried about the macroeconomic effect of a negative demand shock on the economy (prices, income and output). Discuss (and illustrate graphically) the possible policies the country could implement to reduce these effects. (Hint: Using the Aggregate Demand and supply Model)

Answer 1

A negative demand shock in the market will shift the aggregate demand curve to the left and the new equilibrium will be at a lower price and lower output, to correct his negative shock the government need to increase the purchases and decrease the taxes, this will increase the disposable income in the market and shift the aggregate demand curve back to the intial equilibrium.

here, as per the graph the intial equilibrium was at the point where the D2 ,S1 and lRAS meet, after the demand shock the Demand curve will shift to the left and after the government take a corrective action it will come back to the intial output.