What Does Recession Do To Aggregate Demand?

A recession is a time in which the economy grows at a negative rate. In a recession, real GDP falls, average incomes decline, and unemployment rises.

This graph depicts the growth of the US economy from 2001 to 2016. The profound recession of 2008-09 may be seen in the significant drop in real GDP.

Other things we are likely to see in a recession

1. Joblessness

In a downturn, businesses will produce less and, as a result, employ fewer people. In addition, during a recession, some businesses will go out of business, resulting in employment losses. For example, many people in the finance business lost their jobs as a result of the credit crunch in 2008/09. When demand for cars fell, car companies began to lay off staff as well.

2. Improvement in the saving ratio

People tend to preserve money during a recession because their confidence is low. When people expect to be laid off (or are afraid of being laid off), they are less likely to spend and borrow, and saving becomes more appealing.
Keynes observed that during the Great Depression, there was a paradox of thrift: when individuals saved more and consumed less, the recession worsened because consumption fell even more. Individually, individuals are doing the right thing, but because many people are saving more, consumer spending is being reduced even more, worsening the recession.

3. A lower rate of inflation

Inflation in the United States was high in 2008 due to rising oil prices. However, the recession of 2009 resulted in a substantial decline in inflation, and prices fell for a time (deflation)

Prices are under pressure due to a drop in aggregate demand and slower economic development. During a recession, stores are more inclined to offer discounts to clear out unsold inventory. As a result, we have a reduced inflation rate. Deflation occurred during the Great Depression of the 1930s, when prices plummeted.

4. Interest rates are falling.

Interest rates tend to fall during recessions. Because inflation is low, central banks are attempting to stimulate the economy. In theory, lower interest rates should aid the economy’s recovery. Lower interest rates lower borrowing costs, which should boost investment and consumer expenditure.

5. Increases in government borrowing

In a recession, government borrowing will increase. This is due to two factors:

Stabilizers that work automatically. The government will have to pay more on jobless compensation if unemployment rises. Because fewer individuals are working, however, they will pay less income tax. In addition, as business profitability declines, so do corporate tax receipts.
Second, the government may try to utilize fiscal policy that is more expansionary. This entails lower tax rates and higher government spending. The objective is to repurpose unemployed resources by utilizing surplus private sector funds. Take, for example, Obama’s 2009 stimulus program. Look at Obama’s economics.

6. The stock market plummets

Stock markets may collapse as a result of lower profit margins. There’s also the risk of companies going out of business.
If stock markets foresaw a downturn, it’s possible that it’s already factored into share prices. In a recession, stock prices do not always fall.
However, if the recession comes as a surprise, profit projections will be lowered, and stock values will decrease.

7. House prices are dropping.

In this scenario, property values in the United States decreased prior to the recession. The recession was triggered by a drop in house prices. It took them until the end of 2012 to get back on their feet.

In a recession, when unemployment is high, many people may be unable to pay their mortgages, resulting in property repossessions. This will result in a rise in housing supply and a decrease in demand. Because of the prior property boom, US house values plummeted dramatically during the 2008 recession. In truth, the housing/mortgage bubble bust in 2005/06 was a contributing reason to the recession.

8. Make an investment. As companies reduce risk-taking and uncertainty, investment will decline. Borrowing may also be more difficult if banks are low on cash (e.g. credit crunch of 2008). Due to variables such as the accelerator principle, investment is frequently more volatile than economic growth.

A simple AD/AS framework depicting the impact of a decrease in AD on real GDP and price levels.

Other possible effects

The effect of hysteresis. This means that a momentary increase in unemployment could lead to a long-term increase in structural unemployment. Manufacturing workers, for example, required longer to locate new positions in the service sector after losing their jobs during the 1981 recession. See the hysteresis effect for more information.

Exchange rate depreciation is number ten. Depreciation could result from a recession that hits one country more than others. Because interest rates decline, there is less demand for the currency (worse return)

Because of the credit crisis, the UK economy, which is heavily reliant on the finance industry, witnessed a severe fall in the value of the pound in 2008/09.

The Pound, on the other hand, was robust throughout the 1981 recession. In fact, the Pound’s strength contributed to the slump.

11. New businesses and creative destruction Some economists are more optimistic about recessions, claiming that they can force inefficient businesses out of business, allowing more inventive and efficient businesses to emerge.

In a recession, however, good companies can go out of business owing to transient circumstances rather than a long-term lack of competitiveness.

12. Current account with a positive balance. If a country’s domestic consumption falls sharply, the current account deficit may improve. This is due to a decrease in import spending.

The UK’s current account improved through the recessions of 1981 and 1991. However, the recovery in the current account in 2009 was just temporary.

It depends on what caused the recession in the first place. High oil prices, for example, contributed to the recession in the mid-1970s. As a result, in a recession, inflation was higher than usual.
The high value of the Pound hurt the manufacturing (export) sector during the 1981 recession. Because the recession was driven by unusually high interest rates, which made mortgages expensive, homeowners carried a greater burden during the 1991/92 recession. The finance and banking sectors were the hardest hit during the 2008 financial crisis.
It all depends on whether the recession is global or country-specific. The recession in the United Kingdom was worse than everywhere else in the globe between 1981 and 1991.
It all relies on how governments and the central bank react. For example, in 1931, the United Kingdom attempted to balance its budget, which resulted in additional declines in aggregate demand.

In a recession, what happens to aggregate demand?

Two consecutive quarters of negative GDP growth is the usual macroeconomic definition of a recession. When this happens, private companies often reduce production in order to reduce their exposure to systematic risk. As aggregate demand falls, measurable levels of spending and investment are likely to fall, putting natural downward pressure on prices. Companies lay off workers to cut expenses, causing GDP to fall and unemployment rates to climb.

What effects does the recession have on aggregate demand and supply?

A drop in pricing is related with a recession. This makes intuitive sense, but it’s also seen in a graph of aggregate demand and supply during a recession. Businesses must decrease prices to keep sales up when people lose their jobs and can no longer afford to pay as much. The supply and demand curves support this, as a shift to the left in the demand curve results in lower equilibrium price and demand levels, where supply and demand meet.

In a recession, why does aggregate demand fall?

A drop in aggregate demand is the primary cause of recessions (a drop in real GDP) (AD). Several reasons could cause a demand-side shock, including:

There is a financial crisis. When banks run out of cash, they cut back on lending, which affects investment.
An increase in interest rates raises borrowing costs and diminishes demand.
The negative multiplier impact exacerbates the decline in consumer and business confidence.
Inflation and diminished spending power are caused by supply-side shocks, such as rising oil costs. (For example, in the 1970s)
A black swan event is an unforeseen occurrence that is difficult to predict. The Covid-19 flu pandemic, for example, has disrupted travel, supply lines, and normal corporate operations. Both supply and demand are affected by a pandemic.

Is the aggregate demand and supply affected by the recession?

Figure 1: Left Shift in Aggregate Demand and Supply. Negative shocks to aggregate demand or aggregate supply can trigger recessions. (a) A drop in consumer or corporate confidence might cause AD to shift to the left, from AD0 to AD1. In comparison to the previous equilibrium, when AD shifts to the left, the new equilibrium (E1) will have a lower quantity of production and a lower price level (E0). The new equilibrium (E1) in this case is similarly lower than potential GDP. Reduced government expenditure or higher taxes that result in lower consumer spending can also cause AD to shift to the left. (a) If the cost of critical inputs rises, AS will shift to the left, from SRAS0 to SRAS1. In comparison to the initial equilibrium, when SRAS shifts to the left, the new equilibrium (E1) will have a lower quantity of output and a higher price level (E0). The new equilibrium (E1) in this case is similarly lower than potential GDP.

Is inflation lower during a recession?

Inflation and deflation are linked to recessions because corporations have surplus goods due to decreasing economic activity, which means fewer demand for goods and services. They’ll decrease prices to compensate for the surplus supply and encourage demand.

In a worldwide recession, what happens?

A global recession is a prolonged period of worldwide economic deterioration. As trade links and international financial institutions carry economic shocks and the impact of recession from one country to another, a global recession involves more or less coordinated recessions across several national economies.

What is the impact of aggregate demand on economic growth?

A rise in aggregate demand drives economic growth in the short run (AD). If the economy has spare capacity, an increase in AD will result in a higher level of real GDP.

Factors which affect AD

Lower interest rates – Lower interest rates lower borrowing costs, which encourages consumers to spend and businesses to invest. Lower interest rates cut mortgage payments, increasing consumers’ discretionary income.
Wages have been raised. Increased real wages enhance disposable income, which encourages consumers to spend.
Greater government expenditure (G), such as government investments in new roads or increased spending on welfare payments, both of which enhance disposable income.
Devaluation. A decrease in the value of the currency rate (for example, the Pound Sterling) lowers the cost of exports and increases the volume of exports (X). Imports become more expensive as a result of depreciation, lowering the quantity of imports and making domestic goods more appealing.
Confidence. Households with higher consumer confidence are more likely to spend, either by depleting their savings or taking out more personal credit. It encourages spending by allowing increased spending (C) (C).
Reduced taxation. Consumers’ disposable income will increase as a result of lower income taxes, which will lead to increased expenditure (C).
House prices are increasing. A rise in housing prices results in a positive wealth effect. Homeowners who see their property value rise will be more willing to spend (remortgaging house if necessary)
Financial stability is important. Firms will be more eager to invest if there is financial stability and banks are willing to lend, and investment will enhance aggregate demand.

Long-term economic growth

This necessitates an increase in both AD and long-run aggregate supply (productive capacity).

Capital increase. Investment in new manufacturing or infrastructure, such as roads and telephones, are examples.
Increased labor productivity as a result of improved education and training, as well as enhanced technology.
New raw materials are being discovered. Finding oil reserves, for example, will boost national output.
Microcomputers and the internet, for example, have both led to higher economic growth through improving capital and labor productivity. New technology, such as artificial intelligence (AI), which allows robots to take the place of human workers, may be the source of future economic growth.

Other factors affecting economic growth

Stability in the economy and politics. Stability is vital for convincing businesses that investing in capacity expansion is a sensible decision. When there is a surge in uncertainty, confidence tends to diminish, which can cause businesses to postpone investment.
Inflation is low. Low inflation creates a favorable environment for business investment. Volatility is exacerbated by high inflation.

Periods of economic growth in UK

The United Kingdom saw substantial economic expansion in the 1980s, owing to a number of factors.

Reduced income taxes increase disposable income, which leads to increased expenditure and, in turn, stimulates corporate investment.
House prices rose, resulting in a positive wealth effect, equity withdrawal, and increased consumer spending.

What are the consequences of the economic downturn?

Economic constraints imposed to prevent the spread of the coronavirus will cause a recession, one that will be far larger than the one that followed the global financial crisis of 2007/08.

People’s lives are affected by an economic downturn in a variety of ways, including increased unemployment, less economic activity, decreased income and wealth, and increased uncertainty about future jobs and income. A substantial corpus of economic research has looked at how recessions affect people’s health behaviors, health conditions, and death rates, as well as how these outcomes fluctuate between generations and socioeconomic groups.

What does evidence from economic research tell us?

Many studies show that death rates drop during recessions compared to booms, while newer research reveals that the link between mortality and macroeconomic conditions is weaker than previously thought.
In the years following a recession, chronic disease rates rise due to increasing unemployment and other factors.
Depending on their circumstances prior to the recession, different groups of people are affected in different ways. Generations, geographies, and socioeconomic categories all have different affects. A related contribution focuses on the consequences of recessions on the health of children.
The impact of recessions on health vary by health condition, as well as mortality (the rate of deaths) and morbidity (the number of people who die) (the incidence of health conditions or disease in the population).
The influence of a recession on mortality and morbidity varies depending on the time period studied (during the course of the recession itself, in the immediate short run aftermath, or in the long run).

How reliable is the evidence?

The majority of the evidence comes from peer-reviewed studies that rely on data from high-quality administrative or large nationally representative cross-sectional and longitudinal surveys. The data on the average effect of recessions that is, whether recessions have a positive or negative effect on health is equivocal and varies by country, time frame, and recession analyzed (Ruhm, 2015), as well as the level at which geographical regions are aggregated (Lindo, 2015).

Intuitively, it may be natural to believe that mortality rises during difficult economic times. Indeed, when looking at individual-level statistics, such as a study of Pennsylvania workers in the 1970s and 1980s, individuals who lost their employment had higher mortality rates just after they lost them (Sullivan and von Wachter, 2009). Even 20 years after the displacement, the rates of death are higher among people who lost their jobs, despite the fact that the effect fades over time.

However, most studies of recessions prior to the financial crisis of 2007/08 reveal that the rate of deaths is lower during recessions than during booms when looking at mortality across the entire population (not just those who lose a job as a result of a recession) (for example, Ruhm, 2000).

A lot of factors contribute to the decrease in deaths. During a recession, lower general economic activity equals less air pollution, which causes fewer deaths from diseases that are normally made worse by pollution (Janke et al, 2009). This also applies to incidents on the road and in the job (Miller et al, 2009).

Furthermore, when people’s salaries are cut, they are more likely to eat healthier and consume less alcohol or smokes (Griffith et al, 2016; Adda et al, 2009). According to one study, recessions reduce the spread of virus-borne diseases because people travel less across regions for business or pleasure (Adda, 2016).

More recent studies, including studies of European countries, suggest that total mortality does not fall in recessions in the twenty-first century (and notably the recession following the global financial crisis of 2007/08). Instead, it is unaffected by macroeconomic conditions or increases modestly during recessions (see, for example, Ruhm, 2015, for analysis of the United States; or Economou et al, 2008, for a study of European countries).

Many studies have found that mental illness and suicide deaths rise during recessions (for example, Charles and DeCicca, 2008), and a review of the evidence has concluded that the deterioration of mental health during recessions is the only consistent finding across studies (Bells-Obrero and Castell, 2018).

Economic downturns have significant and long-lasting detrimental effects on morbidity. According to one study, even while recessions cut mortality at the time of the recession, employees in their fifties are more likely to die sooner, implying that the long-term consequences on health are negative (Coile et al, 2014). Another study suggests that the global financial crisis of 2007/08 increased the prevalence of chronic illness, particularly mental illness, in the United Kingdom in the two years after the start of the recession (Janke et al, 2020).

Other research has found a relationship between long-term chronic illness and death (Kivimki et al, 2018), suggesting that the long-term impact on mortality could be even worse.

Studies also demonstrate that recessions in early childhood can have an impact on mortality later in life, implying that the impacts of recessions can extend a lifetime for those born during them (Van den Berg, 2006). Because these studies must cover the entire life cycle of these individuals from birth to death in order to collect data, they must cover recessions that occurred many years ago, therefore the question of whether the findings can be applied to today’s situation remains.

Downturns that are part of the cyclical business cycle might have repercussions that are different from more fundamental or structural changes in the economy. The term “deaths of despair” (Case and Deaton, 2015, 2017) was coined as a result of decades of industrial decline in the United States, which has increased mortality, particularly among low-educated men (see also for example, Pierce and Schott, 2020). This type of structural change occurs over numerous business cycles rather than during a single recession, and its consequences are distinct from the health consequences of a recession’s more transient state.

The impact of recessions on children has not been addressed in this summary; nevertheless, a separate contribution explores the ways in which children’s health may be impacted in the current circumstances.

Key Points

The price-quantity pair in which the quantity requested equals the quantity provided is called equilibrium.
Increases in aggregate demand enhance the output and price of a good or service in the long run.
Only capital, labor, and technology affect aggregate supply in the long run.
The aggregate supply influences how much a good or service’s output and pricing rise as a result of the collective demand.

Key Terms

aggregate: a bulk, collection, or sum of particulars; something made up of parts but taken together.
Supply: The quantity of a commodity that manufacturers are willing and able to sell at a given price, assuming that all other variables remain constant.

What factors influence aggregate demand?

Interest Rates: Consumer and corporate decisions will be influenced by whether interest rates are rising or declining. Lower interest rates reduce the cost of borrowing for large-ticket products like appliances, autos, and houses. Companies will also be able to borrow at reduced rates, which is likely to contribute to increased capital spending. Higher interest rates, on the other hand, raise the cost of borrowing for both individuals and businesses. As a result, depending on the magnitude of the rate hike, expenditure tends to fall or grow more slowly.
Household Wealth and Income: As household wealth rises, so does aggregate demand. A decrease in wealth, on the other hand, usually leads to a decrease in aggregate demand. Personal savings increases will also contribute to lower demand for goods, which is common during recessions. When consumers are optimistic about the economy, they are more likely to spend, resulting in a decrease in savings.
Expectations of Inflation: Consumers who believe that inflation or prices will grow in the future are more likely to make purchases now, resulting in increased aggregate demand. However, if customers expect prices will fall in the future, aggregate demand would shrink.