Now what happens is that firms will have to cut down their production process in order to effectively meet the costs incurred or it will come to a position of losses. The cutting down of the production process means decreasing the supply of the firm. As a firm produces lesser than it did before, fewer workers will be needed because the excess labor has been made redundant since fewer employees are now needed to produce lesser output. Moreover, the firm can no longer afford to employ as many workers as it did before. Hence this will eventually give rise to over the course of time as many workers have will have to be laid off in industries due to low activity. This will invariably decrease the total consumption of the population because as the unemployment increases the purchasing power of the people also falls. They are now earning fewer wages and the income effect will lead to a drastic decrease in the consumption. Consumption is one of the major contributors in the aggregate demand function. We define aggregate demand as the total demand for all goods and services produced in the economy at a given time and price level. It is the amount of goods and services in the economy that will be produced at all possible price levels. The aggregate demand is usually described as a linear sum of four separable demand sources.
C = Consumption
I = Investment
G = Government Spending
(X-M) = Net Exports – Net Imports
The graph for AD is as follows:
It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is in fact downward sloping as a result of the Pigou’s wealth effect. Pigou effect is an economics term that refers to the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth,...