Question

What is the effect of the great recession in the short-run and long-run aggregate supply curves and the aggregate demand curve? How the government can return the output level to the initial?

Answer 1

During a recession, aggregate DD is far away from the initial level of output in the short run and aggregate supply will adjust as per DD in the short run and in long run tp overcome recession,policies will lead to both aggregate DD and aggregate supply to return back to its full employment level in the long run as explained in the figure below.

Let's examine the situation graphically using the AD/AS model below. The original equilibrium during the recession is at point E0, relatively far from the full-employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium E1, real GDP rises and unemployment falls and because in this diagram the economy has not yet reached its potential or full-employment level of GDP—any rise in the price level remains muted.

Other policy tools can shift the aggregate demand curve as well. For example, the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by businesses. On the other hand, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.This is how government can return the output level to full employment level.