issues or economic problems at the level of an economy as a whole. It considers the aggregate performance of all the markets in the system. Its variables are Aggregate Demand and Aggregate Supply. AD is the aggregate expenditure on the purchase of the domestically produced goods and services during the accounting period. AS refers to the flow of the goods and services in the economy during the accounting year. (Jain T.R. 2009). Overtime the levels of unemployment, inflation and economic growth in an economy tend to fluctuate; these fluctuations are caused by the business cycle which has four phases: peak, Recession, rough and recovery which affects the economic activities.
Considering the economy where the level of production is below the natural level which means that the economy is in recession. It is a general slowdown in the economic activity, the economic output declines which lead to the unemployment to rise and inflation declines. The causes of recession are determined by both the AD and AS curves. Fall in AD is determined by decline in any of these components: the consumption spending, investment spending, government spending and the net exports spending (Froyen R. 2002). If this happens then according to Keynesian theory (Keynes J. 1936) there will be fall in GDP and the effect of the real GDP depends upon the slope of the AS curve which shifts lefts as the higher prices would increase the cost of production which will shift the short run AS and cause lower GDP and higher inflation .The other effects of recession include a declining demand for output leading to higher level of productivity , even the rise in unemployment would be caused as factory workers would be forced to leave their jobs by the firms, fall in business confidence and profits affecting exports and imports, increasing the government spending. Counties get affected by global recession .For example, a recession in EU could cause a fall in the demand for UK exports which will reduce AD and cause a short term fall in UK’s Real GDP but the effects can be reduced if the domestic demand for goods in UK remains high. (Pettinger T. 2011)
Economists believe that if there is any fall in the GDP it is suppose to be temporary and will return to its natural level when the labour market adjusts the wages which would affect the price. Any fall in AD, would led to short term fall in the real GDP. However, in the great depression of 1930s, Keynes was very critical about these assumptions and brought forward his view that the negative growth for a long period doesn’t clear the market automatically as the prices and wages are sticky, the stickiness of these in the downward direction prevents the economy from experiencing full employment. According to him in recession there is a fall in the consumer confidence which causes rise in the saving ratio which means people tend to spend less of the disposable income and save more which causes further fall in the AD curve (paragraph paraphrased from Arevuo M. 2012).
The AS relation between the price level and the output is positive and the AS curve is upward sloping as will be illustrated in Figure 1. Another characteristic is that the expected price level which works through the wage setting leads to an increase in the actual price level (Romer D. 1996). As the equilibrium in the labour market requires the real wage implied by the wage setting be in accordant with the wage implied by price setting with the assumption that the actual price level is equal to the expected price level.
The AD relation between the price level and output is negative and the AD curve is downward sloping as will be illustrated in Figure 1. AD curve is derived from the equilibrium in the goods market and the financial market. Goods market is the buying and selling of goods and services and is represented by IS curve whereas the money market is the interaction between the demand and supply of money which is set by the central bank of a country and is represented by LM curve. This IS- LM model leads to the derivation of the AD curve and is used to foresee the economy’s response to the fiscal and the monetary policy (Danby C. and Charusheela S. 1998).
Figure 1: Effects of the adjustment process on the price level and output when economy is in recession.
Source: The above self made diagram is enumerated from Blanchard Olivier, Macroeconomics international edition. (See appendix A)
In the figure 1, the equilibrium is given at the point A where the AD and the AS curves intersect, the output and the price level are given by Y1 and P1. Because, the economy is in recession the natural rate of output Y2 is higher than the output Y1 and the gap between the YI and Y2 is called the recessionary gap, the price level P2 is also higher than P1. As the output is lower than the natural level, the unemployment rate is above its natural rate and the tight labour market leads to lower wages and these lower wages lead to lower prices than expected by the wage setters. Now, at price level P1, where the economy is in recession increase in money leads to an increase in the real money stock M/P .Overtime, the adjustment takes place where the economy moves down along the AD curve and this continues till the time the output reaches its natural level at A2 where output is high with low price. Therefore, the basic mechanism through which the economy returns to its natural level in long run is the adjustment process .It works through the price as the price is falling overtime in recession this leads to an increase in the real money which reduces the interest rate, this reduced interest rate leads to higher demand as consumers will demand more at low prices which shifts the AD curve from AD to AD1 in Figure 1 bringing the equilibrium to A1 which is the natural level of the economy. (Paragraph paraphrased from Blanchard O. 1997)
To recover from recession, changes in any of the variable either the AD or AS relation leads to changes in the output and prices .In this case, the output will have to be increased by the right shift of the AD curve and this can be done by the changes in the fiscal and the monetary policy. The central bank can use tight or easy monetary policy and open market operation in which buying and selling of bonds is done to make changes in the supply of money (Ratajczak D. 1987). As the economy is in recession, the central bank can also use expansionary monetary policy which is illustrated in the diagram below:
Figure 2: Effect of the monetary expansion on the interest rate and output.
Source: The self made diagram above is enumurated from Blanchard Oliver, Macroeconomics international edition (See appendix B )
In figure 2, the interest rate and the output is shown by i1 and Y1. The point if equilibrium where the IS and LM curve intersect is at point A which correlates Point A in figure 1 .In monetary expansion the central bank increases the money supply which shifts the curve downward from LM to LM1 and downward movement occurs on the IS curve forming new equilibrium at point A1 which also correlates to point A1 in figure 1.This increase in money supply leads to increase in money stock (M/P) assuming that the price doesn’t change this shifts the LM curve further from LM1 to LM2 .But , to recover from recession the price level increased in figure 1 to reach the natural level of output ,so the LM curve shifts back from LM2 to LM1. Therefore, the interest rate decreases and the output increase at point A1 with interest rate i2 and level of output Y2.
Expansionary monetary policies are designed to increase the money supply by the central bank. This increases the Aggregate Demand which will lead to increase in price level and will increase the profit potential for business as now businesses would now respond to the increase in profit by increasing the output and reducing the unemployment rate which means that the employment level would rise (Maurice M. 2012) .The interest rate is cut down which reduces the cost of borrowing and people wish to spend more.
To conclude, the AD-AS model determines the equilibrium price level and equilibrium level of real GDP. Considering what happens in this situation when the level of production is below the natural level i.e. economy is in recession. With adjustment process, the AD curve shifts upward to reach the natural level of output and there is movement along the AS curve. In recession even when the central bank increases the money supply by cutting the interest rate to stimulate the demand means that the lower the interest rate lower will be the cost of borrowing and therefore people will tend to spend and invest more. But, this policy can also prove to be inefficient as the firms may be reluctant to invest as they don’t see any increase in the demand in spite of cheap borrowing . Moreover, it gets difficult to increase the aggregate demand during recession.