Use an AD-AS graph to demonstrate and explain the price-level and real-output outcome of an anticipated decline in aggregate demand, as viewed by RET economists. (Assume that the economy initially is operating at its full-employment level of output.) Then demonstrate and explain on the same graph the outcome as viewed by mainstream economists.

For an anticipated decline in aggregate demand to AD’ from AD, the firms are aware completely of the price fall from P to P’ and anticipate that nominal wages will decline by the same percentage amount as the declining price level, leaving profits unchanged. So, the producers increase the supply, and the economy moves directly from point a to b. Deflation occurs in the economy, but it produces at the full employment level.

The mainstream economists suggest taking the help of the monetary or fiscal policy when the AD falls to restore the economy to the full employment level. So, in the above figure, the mainstream economists will advocate an expansionary monetary policy that lowers the interest rate and encourages producers to increase AS to AS’. In this process, the economy reaches from point a to b. In the absence of this measure, the economy will stay where the AD’ intersects AS.