The theory that the economy automatically adjusts itself is called the Classical Theory of Supply and Demand. This theory states that prices and quantities of goods adjust to their equilibrium levels.
Prices adjust due to changes in supply and demand, and quantities of goods adjust due to changes in cost. For example, if there is a decrease in demand for apples, then the price will decrease and farmers will harvest fewer apples due to lower profitability.
Under this theory, there are no direct interventions the government can make to fix an economic problem. The only thing the government can do is change taxes which would indirectly affect supply and demand, but not directly fix the problem.
This theory has been heavily criticized for not taking into account other factors that influence the economy. Critics have said that this theory ignores institutional factors such as policies put into place by the government and global factors such as climate change and rising oil prices.
Lower production
When the economy adjusts, firms produce less and workers earn less. When aggregate demand falls, production also falls.
This is a normal and healthy part of the economy. Production is only reduced when the price of a good or service is lowered due to a drop in demand.
If production was kept at the current level, then there would be too much of that good or service and the price would fall even further. By only producing what is demanded, prices stabilize.
Consumers have more money to spend when prices go down, which in turn increases demand for goods and services. This influx of demand then helps to offset some of the decline in aggregate demand caused by the reduction in price.
Higher unemployment
Another channel through which the economy can adjust to a decline in aggregate demand is through higher unemployment.
As output falls, firms can reduce wages and employment in order to save money. Workers then have an incentive to accept lower wages and employment, since there are fewer jobs available.
This way, the total amount of labor employed declines, which helps bring the economy back into balance. If wages stayed the same while output fell, then less labor would be employed, again helping to restore equilibrium.
Both of these occur because firms have to pay less for the same amount of goods and services they produce. This helps them survive economically during a recession, which is a good thing!
The problem occurs when unemployment stays high for a long time. Then people can’t afford to live as well as they could before and may need assistance from the government or other organizations.
All of the above
As we have seen, the economy is a system of millions of people, corporations, and governments that all work together to produce the goods and services that we all need and want.
Automatic economic adjustments happen due to changes in aggregate demand. When AD decreases, prices and wages adjust downward, which reduces spending. This creates a decrease in demand for production which slows production of goods and services.
These downward pressures on prices and wages are called deflation. Although deflation sounds bad, it’s actually a normal part of the automatic economic adjustment process. It helps prevent inflation from getting out of control.
When deflation occurs, it forces people to spend money before their money is worth less. This increased spending stimulates the economy and counteracts the decline in spending that caused the deflation to begin with.
None of the above
A decrease in aggregate demand, or the total demand for goods and services in an economy, causes a recession. A decline in aggregate demand can be the result of a drop in worker income, decreased spending by businesses, or reduced government spending.
Businesses may reduce their employment or cut prices to sell their products, but overall they will make less money. Workers will have less income to spend on goods and services, thus reducing aggregate demand.
Governments may invest less in infrastructure or cut spending on social programs like Medicare and unemployment benefits. This too reduces overall spending as people have less income to use for other things.
Theories about what causes recessions vary depending on who does the explaining, but one common theory is that recessions are caused by imbalances in the economy. An imbalance occurs when something changes and the economy takes time to adjust to the change.
Price and output adjust to demand changes, but not necessarily immediately or completely
As we have seen, the price and output of goods and services adjust to changes in aggregate demand.
However, this adjustment does not always happen immediately or completely. In fact, in most cases, prices and output only adjust partially.
That is why we sometimes see sales where items are sold at lower prices than usual or shortages where there is not enough of a product available.
In the case of inflation, prices may only increase slightly or may even decrease while overall average aggregate demand has decreased. This is because businesses will keep prices stable to retain customers, which will counter the effect of a decrease in aggregate demand.
We will discuss this in more detail later, but for now remember that on average, prices adjust to counteract changes in aggregate demand.
