During the recession of 2007-2009, the U.S. economy was experiencing a decrease in home prices and consumer wealth, a credit crisis in the financial markets, and declining consumer and business confidence. What components of aggregate demand were affected and what was the impact on real output?What were the policy options?

It has been given that during recession of 2007-2009, the US economy was experiencing a decrease in home prices and consumer wealth, a credit crisis in the financial markets, and declining consumer and business confidence.

Decrease in home prices and consumer wealth implies that purchasing power of households was declining. In addition to this consumer confidence was also decreasing. Both these factors had result in deceased consumption spending by households during 2007-2009.

Business confidence was also decreasing. This means that during 2007-2009, businesses believed that future economic scenario will be worse than present economic scenario. As businesses were not seeing the improvement in economic scenario coupled with credit crisis in financial markets, they had put on hold the new investment with respect to new projects as well expansion of existing production capabilities. This means businesses had reduced their investment spending during 2007-2009.

Consumption and investment are component of aggregate demand.

So, consumption and investment component of aggregate demand were affected by the recession of 2007-2009.

Both consumption and investment component of aggregate demand were declining during recession of 2007-2009. This decline has brought a decline in aggregate demand as well. Decline in aggregate demand, in result, has led to decline in real output as well during recession of 2007-2009.

The policy options were as follows –

1. Government spending had to be increased. This will prop up the aggregate demand as government spending is a component of aggregate demand. This will induce the businesses to increase production to cater to increased demand being made by government. This will lead to increase in real output and elimination of recession.

2. Tax rebates had to be extended to households as this will prop up their income and there by uplift their purchasing power. This will induce them to consume more there by uplifting aggregate demand and economy out of recession.

3. Rule tightening with respect to housing market and financial markets should be undertaken so that crisis can be arrested and consumer and business confidence can be uplifted. This will prop up aggregate demand and thereby pull the economy out of recession.