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What Is the Connection Between Aggregate Demand and Unemployment?

Changes in aggregate demand may impact the unemployment level.
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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 22 July 2014
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There is a connection between aggregate demand and unemployment rates within a nation. Changes in aggregate demand are sometimes driven by a shift in the economy, creating a series of circumstances that may increase the level of unemployment. This creates a situation in which changes in aggregate demand due to a downturn in the economy may in fact lead to an increase in unemployment, a factor that is likely to further cause the demand for certain goods and services to decrease.

The relationship between aggregate demand and unemployment can be explained with a simple example. When the economy of a nation enters into a period of recession, there is a good chance that some companies will lay off a portion of their workforce in order to save money and weather the tough economic period. Those employees who suddenly find themselves in the ranks of the unemployed begin to look for ways to curtail spending, making it possible to continue paying essential expenses such as rent or a mortgage. The result is that any goods they once considered desirable but are now considered too expensive and non-essential are not longer purchased. This in turn leads to a decrease in the aggregate demand that encompasses all the goods and services sold within that country.

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As the demand for some goods and services decreases, this means the overall or aggregate demand within the nation also undergoes some degree of reduction. As the gross domestic product (GDP) falls, businesses that produce those products which are no longer in demand may try several strategies to reverse the trend, including lowering prices for a time. If this fails, then there is no choice but to begin reducing the number of individuals employed with those firms, which causes the unemployment for the nation to continue increasing. Here, the relationship between aggregate demand and unemployment comes full circle as the falling demand helps to push unemployment upward.

Monitoring the relationship between aggregate demand and unemployment can help government officials and others who are concerned with the economy to identify developing trends that are likely to be characterized by reduced demand for key products produced and sold in the nation and correlate that change with unemployment figures. From there, steps can be taken to slow the downward spiral, stabilize the economy, and hopefully provide motivation for companies to recall laid-off workers and begin the task of reducing the unemployment rate. When done early on, identifying trends based on shifts in aggregate demand and unemployment can help to minimize the impact and the duration of a downward trend in the economy, and make it easier for that economy to return to a more satisfactory level of prosperity.

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