Question

True or False

A recession is usually described a fall in aggregate demand leading to decreased inflation and decreased output.

Answer 1

The given statement is true: Recession is usually described as a fall in aggregate demand leading to decreased inflation and decreased output.

The above statement can be proved to be true with the help of the Classical AD-AS model explained below:

o Refer to the below figure that presents an economy of any fictional country. The X-axis shows the Real GDP or the aggregate output whereas Y-axis shows the Price Level. Initially the economy is at its long-run equilibrium point A where the Long-run Aggregate supply curve (LRAS), Short-run Aggregate Supply curve (SRAS) and initial aggregate demand curve AD1 intersects. Here, the equilibrium price level is P1 and the real GDP is equal to potential level of GDP “Yn”.

o Let’s say the economy experiences a huge demand shock because of some major epidemic like COVID-19 these days. Due to the increase in the spread of the virus and implementation of lockdown measures, households and business firms are induced to cut down on consumption and investments spending which is critical for any country’s economic growth. This results in a decrease in overall aggregate demand and the AD curve shifts downwards from AD1 to AD2.

o In response to the fall in demand, many businesses decides to cut down production or shut down operations (either temporarily or permanently) in order to avoid any future losses. In this whole process, as aggregate production falls the demand of labor falls too. Many employees are even laid from their current organization that further increases the unemployment rates.

o Thus a fall in Aggregate Demand puts a downward pressure on the prices including wages due to higher unemployment. The price level falls from P1 to P2 and output falls to lower levels like Y’. The economy moves down to short-run equilibrium at point B. At this point, actual level of GDP falls below the potential GDP, the economy is said to experience a Recessionary Gap in the short-run , which is equal to Y’ – Yn. Hence during this phase of business cycle, inflation rates as well as output growth, both are poor.

LRAS Prices SRAS A P1 B P2 AD1 AD2 Y' Yn Real GDP/ Output