Question

How does a fall in aggregate demand affect prices, interest rates and output in the long and short-run (Giving reference to the IS-LM AS-AD model throughout).

Answer 1

AGGREGATE DEMAND

aggregate demand or domestic final demand is the total demand for final goods and services in an economy at a given time.

FALL IN AGGREGATE DEMAND

A fall in aggregate demand indicate a decrease in spending by the people and a slow down in the economy,Economy reaches equilibrium when AD=AS.

1. IMPACT ON INTEREST RATES-When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand.
2. IMPACT ON PRICE-As a result of falling aggreagate demand the economy reaches the situation AD<AS,in such a condition price level falls as there is excess supply and least demand.
3. IMPACT ON OUTPUT-As aggregate demand decreases and less and less are demanded there will be excess stock with production units and many unsold products all this will lead producers to cut short the output.

IN long run all the above mentioned impacts will be overcome with appropriate fiscal measures like increase money supply and also due to the aautomatic results like decrease in price,decrease in interest rates ettc will automatically lead to an increase in AD and economy gaining back its equilibrium.