Question

During the Great Recession, real gross domestic product (GDP) decreased and unemployment increased, yet the price level did not change much at all. Using the aggregate demand and aggregate supply model, explain what caused this.

Answer 1

During great recession, aggregate demand decreased, shifting AD curve leftward which decreased price level, decreased real GDP and increased unemployment. At the same time, aggregate supply also decreased, shifting short run AS curve leftward, increasing price level and decreasing real GDP. The net effect was a definite decrease in real GDP and increase in unemployment, but price level was the same because leftward shift in AD curve was equal in magnitude to leftward shift in SRAS curve.

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial long-run equilibrium price level P0 and initial equilibrium real GDP (= Potential GDP) Y0. During recession, AD0 shifted left to AD1 and SRAS0 shifted left to SRAS1, intersecting at point B with lower real GDP Y1 but same price level P0.