Question

Suppose firms become very pessimistic about future business conditions and significantly reduce investment spending. Show the short-run effect of this pessimism on the aggregate-demand curve.

Answer 1

A significant reduction in investment spending due to pessimism among firms causes a leftward shift in the aggregate-demand curve, leading to reduced economic output and increased unemployment in the short run.

Step-by-step explanation:

Short-Run Effects of Pessimism on Aggregate-Demand Curve

When firms become pessimistic about future business conditions and significantly reduce investment spending, there is a short-run effect on the aggregate-demand curve. This pessimism and subsequent reduction in investment result in a leftward shift of the aggregate-demand curve. The decrease in investment reduces overall spending in the economy, leading to lower levels of aggregate demand at each price level. This shift can result in a decline in economic output and an increase in unemployment, as firms require less labor due to the decrease in production and investment.

The pandemic-induced recession serves as a real-world example of such a scenario, where fears and restrictions related to health crises can lead to decreased consumer and business spending. This leads to similar shifts in the aggregate demand and reflects declines in consumption and investment components of GDP.

A shift to the left in the aggregate demand curve, as depicted in various figures from economic literature, results in movement from the original equilibrium to a new, lower equilibrium point. This new equilibrium is characterized by a reduction in the quantity of aggregate demand and a decrease in the overall price level, indicating a period of economic contraction or possibly disinflation.

Answer 2

A very pessimistic outlook by firms regarding future business conditions that leads to reduced investment spending causes a leftward shift in the aggregate-demand curve, resulting in lower output and higher unemployment in the short run.

Step-by-step explanation:

When firms become very pessimistic about future business conditions and consequently reduce investment spending, the short-run effect on the aggregate-demand curve will be a leftward shift. This is due to a drop in investment, which is one of the components of aggregate demand—the total amount of goods and services demanded in the economy at a given overall price level and in a given time period. Investment is a major component of aggregate demand, so a significant reduction in investment spending will reduce aggregate demand.

The leftward shift of the aggregate-demand curve represents a decrease in total spending, which leads to lower output and employment in the short run. According to the AD-AS (aggregate demand - aggregate supply) model, a steeply sloping aggregate demand curve indicates that changes in price levels do not have a large effect on the quantity of aggregate demand. Nonetheless, a shift in the curve itself, such as one caused by a change in investment sentiment, results in a movement to a new equilibrium point with potentially lower output and higher unemployment.

The economic impact of a pandemic provides a real-world example of such a scenario, where aggregate demand can be severely affected, as seen with reduced consumer spending on services like restaurants and travel, and firms curtailing investments due to an uncertain future. Overall, a more pessimistic outlook leads to reduced economic activity and a contractionary effect on the economy, as depicted by the leftward shift in the aggregate-demand curve.