In 2008, the world experienced one of the worst recession that led to drop in macroeconomic indicators such as employment statistics, household income, rise in prices of food commodities, the rise of unemployment rates, and shocking GDP rates. Generally, it was the crush of many business activities, especially those related to demand and supply of goods, which led to recession. In other words, recession occurs when there is a drop in consumer buying, leading to a supply shock. In most cases, when the supply side of the economy is affected, the economy bubbles. When there is recession, it means that even the stock market is affected. Nevertheless, the natural happenings within the macroeconomic environment can self correct the economy, and move it back to full employment.
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Aggregate Demand – Aggregate Supply Model
In order to explain the possibility of this situation happening, it is imperative to apply the income-expenditure model or the aggregate demand – aggregate supply model. This theory is based on four assumptions namely: macroeconomic equilibrium, aggregate supply and demand, the consumption function, and the aggregate expenditure and equilibrium. Indeed the crash of stock markets has proved to be a menace to many economies. For instance, if the aggregate demands prove to be more than the income on payments, then we expect more firms to trade in the stock market.
However, if the demand of shares in the stock market drops, it means that there will be a drop in income payments and many firms will be affected. In this model, the stock market is entirely dependent on the income payments. The income payments also depend on the aggregate demands. For the full employment to resume there will be a supposed free flow of income, increased production of local goods, and reasonable interest rates.
In economic terms, the shrinking of the aggregate demands leads to stalled production of commodities and declining of employment indexes. Consequently, one expects that price of shares in the stock market to go down. However, if the situation reverses itself, the economy will improve. On the other hand, if there is higher aggregate demands, inflation predicaments arise. Evidently, most households either spend their income on consumption or savings. Indeed, there is no problem with consumption as it is all about buying the final goods. However, on savings, households investing their money in stock market will be at risk if there is stock market crash, and that is why savings are a leakage in a circular flow economy. Investing this money in stock market will improve the economy and return it to full employment.
For the economy to self correct and move back to full employment, it is not a single day task. Certainly, a number of things must take place. For example, the supply of money must be constant. If there is a sustained flow of money, it means many people will invest in stock markets and full employment will resume. This is known as wealth check. Additionally, if there is an increase in prices of commodities and the supply of money is low; many people will not trade in the stock market. Thus, an improved supply of money will lead to increased transactions and full employment will resume. It is also imperative to note that the fall of interest rates will also lead to improved investment spending—positive aggregate demand—leading improved economy and hence, full employment.