Final answer:
The wealth effect describes how a decline in the stock market reduces consumer wealth, leading to lower spending and decreased aggregate demand.
A rise in the supply of funds can cause interest rates to drop, encouraging spending and increasing aggregate demand. During a recession, expansionary fiscal policy is used to stimulate aggregate demand through government spending or tax cuts.
Step-by-step explanation:
The process through which a major decline in the stock market leads to a change in aggregate demand is described by the wealth effect. When stock prices fall significantly, investors see a decline in their wealth which may lead to reduced spending.
This reduction in consumer spending decreases aggregate demand, potentially leading to a slowdown in economic activity.
This phenomenon is observed when there are shifts in the financial market as well. For example, a rise in the supply of funds in the financial market can lead to a decline in interest rates, making it cheaper for businesses and consumers to borrow and spend, which can increase aggregate demand.
During a recession, expansionary fiscal policy is generally considered more appropriate.
The government may increase spending or decrease taxes to boost aggregate demand, which is illustrated by a rightward shift of the aggregate demand curve on the aggregate demand and aggregate supply diagram.