Readers Question: how to illustrate the world financial crisis by using the graphs of aggregate demand and aggregate supply?
Aggregate demand has fallen because:
- Bank lending decreased due to the credit crisis and shortage of bank funds. The shortage of bank lending has reduced investment and consumers spending (both components of AD.)
- Falling house prices. The credit crisis has reduced the availability of mortgages and therefore reduced demand for buying houses. Also, house prices were overvalued. So with fewer mortgages available prices have been falling significantly. The fall in house prices has caused a negative wealth effect. This has led to lower consumer confidence, lower equity withdrawal and a decline in consumer spending.
- Fall in global growth. The decline in economic growth has caused a decline in exports and world trade, further reducing aggregate demand.
- The decline in confidence. The well-publicised problems of the banking sector and stock market falls have reduced consumer confidence and led to a change in attitudes. Rather than spending on credit people are trying to improve their savings and reduce their debt.
- Multiplier effect. The initial fall in demand causes a fall in output and rise in unemployment. However, with higher unemployment this causes lower spending and further falls in economic growth.
- Cost-push pressures
In early 2008, there was an increase in oil prices which led to cost-push inflation. This caused SRAS to shift to the left and encouraged Central Banks to keep interest rates relatively high.
This possibly aggravated the recession. But, I don’t think it was a major factor.
For more details see: Financial Crisis explained