During a recession, a significant decline in aggregate demand (AD) leads to reduced output and increased unemployment. To illustrate this using an Aggregate Demand and Aggregate Supply (AD-AS) diagram:
- Initially, the economy is at equilibrium where the AD curve intersects the Aggregate Supply (AS) curve at the potential level of output (Yf). This is the point where the economy is stable, with full employment and optimal production.
- However, when there is a fall in aggregate demand due to factors such as decreased consumer spending, lower business investment, or reduced government expenditure, the AD curve shifts to the left (from AD1 to AD2). This new intersection point with the AS curve occurs at a lower level of output (Y1), indicating a recession.
If policymakers take no action, the economy may initially experience a prolonged period of low output and high unemployment. Over time, several adjustments occur:
- The decrease in production leads to falling prices due to reduced demand (deflationary pressures). This can help restore some equilibrium as lower prices eventually stimulate demand.
- As wages and prices adjust, firms might begin to hire again, although this can take a considerable amount of time. The economy starts to recover, moving back towards its potential output.
- However, without any intervention by policymakers (like stimulus measures), the recovery could be slow and painful, resulting in prolonged economic hardship.
In conclusion, a recession driven by falling aggregate demand can lead to a cycle of low growth and high unemployment. If left unchecked, the economy may eventually recover through natural market adjustments, but this process can be lengthy and fraught with difficulties for those affected.