During the financial crisis in autumn 2008, the financial system delivered a sobering shock to the economy when the stock market lost about half of its value. Soon afterward, consumer spending came to a screeching halt. Within six months of the crash, GDP fell by 2.5% and the price level fell by 2.8%. Show how an analysis of aggregate demand and aggregate supply could have predicted this short-run effect on aggregate output and the aggregate price level. Assuming no government intervention, what would you have predicted in the long run?

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STEP | 1 Begin by drawing and labeling the aggregate demand curve. Then draw and label the short-run aggregate supply curve. Next, find the initial equilibrium price and output levels and label them on your graph as well.Read pages 457–458 and review Figure 16-9.

The aggregate demand curve and the short-run aggregate supply curve are shown in the following diagram. The initial equilibrium point is labeled E₁, the initial price level is labeled P₁, and the initial output level is labeled Y₁.

STEP | 2 Using your graph from Step 1, analyze the short-run effect of the stock market fall on aggregate demand and aggregate supply by drawing a new curve representing aggregate demand after the stock market fall.Read page 458 and review Figure 16-10, panel (a).

A decrease in household wealth will reduce consumer spending. Beginning at the equilibrium point, E₁ in the diagram below, the aggregate demand curve will shift from AD₁ to AD₂. The economy will be in short-run macroeconomic equilibrium at point E₂. The aggregate price level will be lower than at P₁, and aggregate output will be lower than output at the original equilibrium point.

STEP | 3 Draw the long-run aggregate supply curve through the initial equilibrium point E₁, and label the recessionary gap.Read pages 460–462 and review Figures 16-12 and 16-13.

The long-run aggregate supply curve is drawn in the following diagram. The economy now faces a recessionary gap between Y₁ and Y₂.

STEP | 4 What would you predict in the long run?Read pages 460–462 and review Figure 16-13.

As wage contracts are renegotiated, nominal wages will fall and the short-run aggregate supply curve will shift gradually to the right over time until it reaches SRAS₂ and intersects AD₂ at point E₃. At E₃, the economy is back at its potential output but at a much lower aggregate price level, as shown in the following diagram.