Question

During the Great Recession of 2007-08, the US economy experienced a sharp decline in

aggregate demand. Study the effects of this decline on output, real interest rates and prices using

both IS-LM and AS-AD models. What stabilization policies would be appropriate during a demand-driven recession?

Answer 1

(1) IS-LM model

A recession reduces aggregate demand, which decreases output. The IS curve shifts leftward, decreasing interest rate and decreasing output. In following graph, IS0 and LM0 are initial IS and LM curves, intersecting at point A with initial interest rate r0 and output Y0. As IS0 shifts right to IS1, it intersects LM0 at point B with lower interest rate r1 and lower output Y1.

LMo o 150 YI Yo

(2) AD-AS model

Lower aggregate demand shifts AD curve leftward, decreasing both price level and real GDP. In following graph, AD0 and SRAS0 are initial aggregate demand and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As aggregate demand decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.

SRASO ADO AD Y YI Yo

(3) A demand-driven recession needs expansionary fiscal and monetary policies. Expansionary fiscal policy needs higher government spending and/or lower tax, which increases aggregate demand. Expansionary monetary policy increases money supply, which decreases interest rate an increases investment, thus increasing aggregate demand.