The Effects Of A Shift In Aggregate Demand

Suppose that for some reason a wave of pessimism suddenly overtakes the economy. The cause might be a scandal in the White House, a crash in the stock market, or the outbreak of a war overseas. Because of this event, many people lose confidence in the future and alter their plans. Households cut back on their spending and delay major purchases, and firms put off buying new equipment.

What is the impact of such a wave of pessimism on the economy? Such an event reduces the aggregate demand for goods and services. That is, for any given price level, households and firms now want to buy a smaller quantity of goods and services. As Figure 31-8 shows, the aggregate-demand curve shifts to the left from AD1 to AD2.

In this figure we can examine the effects of the fall in aggregate demand. In the short run, the economy moves along the initial short-run aggregate-supply curve AS1, going from point A to point B. As the economy moves from point A to point B, output falls from Y1 to Y2, and the price level falls from P1 to P2. The falling level of output indicates that the economy is in a recession. Although not shown in the figure, firms respond to lower sales and production by reducing employment. Thus, the pessimism that caused the shift in aggregate demand is, to some extent, self-fulfilling: Pessimism about the future leads to falling incomes and rising unemployment.

Figure 31-8

A Contraction in Aggregate Demand. A fall in aggregate demand, which might be due to a wave of pessimism in the economy, is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. The economy moves from point A to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2. Over time, as perceptions, wages, and prices adjust, the short-run aggregate-supply curve shifts to the right from ASj to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. The price level falls to P3, and output returns to its natural rate, Y1.

Price Level pi p2 p3

Short-run aggregate supply, ^Si

Short-run aggregate supply, ^Si

Price Level

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