Question

During the Great Depression, the U.S. economy experienced a falling price level and declining real GDP. Using an aggregate demand and aggregate supply diagram, illustrate and explain how this could occur.

Short answer

Answer: Falling price levels and declining real GDP during the Great Depression are a result of leftward shifts in both aggregate demand and aggregate supply curves. Factors such as lower consumer spending, reduced business investment, tighter monetary policy, falling productivity, and declining resource prices contributed to these shifts, leading to a new equilibrium with a lower price level and lower real GDP. This demonstrates the interplay between aggregate demand and aggregate supply in the U.S. economy during the Great Depression.

Step-by-step solution

Draw the initial aggregate demand and aggregate supply diagram

Begin by drawing an initial diagram that includes a downward-sloping aggregate demand (AD) curve and an upward-sloping aggregate supply (AS) curve. The intersection of these curves determines the initial equilibrium price level (P1) and real GDP (Y1).

Explain the changes in aggregate demand during the Great Depression

During the Great Depression, multiple factors led to a decrease in aggregate demand, such as lower consumer spending, reduced business investment, and tighter monetary policy. These factors caused the aggregate demand curve to shift to the left.

Explain the changes in aggregate supply during the Great Depression

At the same time, the Great Depression also caused changes in aggregate supply. Factors such as falling productivity and declining resource prices resulted in a leftward shift of the aggregate supply curve.

Illustrate the shifts in aggregate demand and aggregate supply on the diagram

On the initial diagram, show the shifts in both curves by drawing new aggregate demand (AD') and aggregate supply (AS') curves to the left of the initial curves. The intersection of these shifted curves determines the new equilibrium with a lower price level (P2) and a lower real GDP (Y2).

Explain how the shifts in aggregate demand and aggregate supply resulted in falling price levels and declining real GDP

The leftward shift in both the aggregate demand and aggregate supply curves resulted in a new equilibrium with a lower price level (P2) and lower real GDP (Y2). This illustrates how the U.S. economy experienced falling price levels and declining real GDP during the Great Depression. These shifts were caused by various factors that contributed to reduced demand for goods and services as well as reduced overall production capacity in the economy.