All else assumed constant decreases in aggregate demand tend to result in decreases in output and GDP. True or False?
The correct answer and explanation is:
Correct Answer: True
A decrease in aggregate demand, assuming all else is held constant, typically leads to a decrease in both output and Gross Domestic Product (GDP). Aggregate demand refers to the total demand for goods and services within an economy at a given overall price level and during a specific period. It is made up of consumption, investment, government spending, and net exports.
When aggregate demand falls, it means that households, businesses, governments, or foreign buyers are spending less on the country’s goods and services. As a result, businesses respond to the falling demand by reducing production. This reduction in production leads to lower levels of output. Since GDP measures the total value of goods and services produced in an economy, a decline in output directly reduces GDP.
In the short run, prices and wages tend to be sticky, meaning they do not adjust immediately to changes in economic conditions. This inflexibility causes output rather than prices to bear the brunt of changes in demand. Lower aggregate demand leads to unused capacity in businesses, reduced profits, and layoffs. These factors compound the decline in output as consumer confidence and spending fall even further.
This phenomenon is especially noticeable during economic recessions. For instance, during the global financial crisis of 2008, aggregate demand fell sharply, and many countries experienced contractions in GDP and a rise in unemployment. Governments often respond to falling aggregate demand through expansionary fiscal or monetary policies, such as increased public spending or interest rate cuts, in an attempt to boost demand and stimulate economic activity.
In conclusion, all else being equal, a decrease in aggregate demand generally causes a decrease in both output and GDP, especially in the short run before prices and wages can fully adjust.