A negative demand shock caused by reduced world demand for domestic goods or decrease in investment, will shift the AD curve downward from AD0 to AD2 which in conjunction with SRAS give a lower level of GDP (Y2) thus, opening up the deflationary gap Y2-Y3. The automatic stabilizers, viz., cost reductions due to low input demand and lower wages are not as quick in the recessionary phase (in fact they are sticky) as they are active in the expansionary phase. The adjustment process is sluggish, and only after a very long time, AS curve will shift rightward to SRAS2 to put the economy back at the potential GDP level Yf. The monetary policy should be used here to make a suitable reduction in interest rates, increase investment and raise aggregate demand to AD0 and achieve Yf level of GDP. The policy should be appropriately timed, because if the interest rate reduction takes place when the economy was already approaching any point between A and E. In such a case, the low interest rate will raise AD to intersect SRAS2 beyond the GDP level Yf thus opening up the inflationary gap.
The case for an active policy response may be much stronger in the event of a negative demand shock. This is because there is a good reason to believe that automatic adjustment processes are much slower working in downward direction than an upward direction because of the asymmetry in the aggregate supply curve and the (possible) fact that money wages are slower to adjust down than up. If this is true, with the economy stuck for some time around point D, a lowering of the interest rates would help shift production back towards point A, as would a cut in taxes or an increase in government spending. Again there would be difference in composition of GDP but not the level (in equilibrium).SUBMIT ASSIGNMENT NOW!