Bus 305

Week5 Module 5 Case

March 17, 2010

Recessions and Economic Stimulus

A recession is a period of decline in total output, income, employment, and trade. This downturn, which last 6 months or more, is marked by the widespread contraction of business activity in many sectors of the economy. But because many prices are downwardly inflexible, the price level is likely to fall only if the recession is severe and prolonged-that is, only if a depression occurs.

Why a recession might occur? The aggregate demand aggregate supply model is a variable-price model that enables analysis of simultaneous changes of real GDP and the price level. The aggregate demand curve is down sloping because of the real-balances effect, the interest-rate effect, and the foreign purchases effect. The real-balance effect indicates that inflation reduces the real value or purchasing power of fixed-value financial assets, held by households, causing cutback in consumer spending. The interest-rate effect means that, with a specific supply of money, a higher price level increases the demand for money, thereby raising the interest rate and reducing investment purchases. The foreign purchases effect suggests that an increase in one country’s price level relative to the price level relative to the price levels in other countries reduces the net export component of that nation’s aggregate demand.

The determinants of aggregate demand consist of change in consumer spending (consumer wealth, consumer expectations, household indebtedness and taxes) Change in investment spending (Interest rate, expected returns, expected returns) Change I government spending and Change in net export spending (National income abroad and exchange rates).

Shifts of the aggregate demand curve to the left of the full employment output cause recession, negative GDP gaps, and cyclical