What is the consequence of deflation in terms of aggregate demand?

Deflation refers to the decrease in the average price level of good and services. It is measured by a decrease in the Consumer Price Index. It happens when the rate of inflation becomes negative i.e. below 0%. In other words, it is defined as a general decrease in consumer prices and assets but the increase in the value of money. It occurs during a deep recession when there is a sustained fall in economic output and demand.

Aggregate demand (AD) is a measure of the amount of goods and services that will be purchased at various prices which shows the quantities of real domestic output (Guell, 2012). Deflation is sparked by an increase in supply and also tend to happen when the economy’s capacity, as indicated by the position of the Aggregate Supply (AS), grows at a faster rate than aggregate demand (AD). In this situation, firms have to cut their product prices in order to stimulate sales and get rid of stocks. In another side, aggregate demand falls and results in a recession when the business and consumer confidence in the economy declines.

Deflation is caused by the fall in aggregate demand which in turn lower price level. Aggregate demand directly affects aggregate employment and output. The reduction in aggregate demand reduces output because of firm’s ability to sell output declines after aggregate demand fall and they, therefore, cut production to serve their own interest (Fazzari, Ferri, & Greenberg, 1998). There are several reasons for the fall in aggregate demand. If the government cut the wages of public sector workers and cut spending then it creates fiscal austerity which provokes to fall in spending and eventually the aggregate demand falls. Secondly, while in a serious recession, people expect a bad outcome about the future that leads to cut back on spending and increase their personal savings. This paradox of thrift causes lower demand where a firm again has to try and cut prices to encourage sales. Thirdly, the tight monetary policy and overvalued exchange rate and high-interest rates also cause a fall in aggregate demand.

References

Fazzari, S. M., Ferri, P., & Greenberg, E. (1998). Aggregate demand and firm behavior: A new perspective on Keynesian microfoundations. Journal of Post Keynesian Economics, 20 (4), 527-558.

Guell, R. C. (2012). Aggregate Demand and Aggregate Supply. In R. C. Guell, Issues in Economic Today (sixth ed., pp. 100-101). New York, United States: McGraw-Hill.

Guell (2015), in their book Issues in Economics Today, deflation is that destructive cycle in the economy majorly prevails when the average price level persistently fall. The cause of deflation is generally credited to bad government policies. Such kind of economic situation is rare and must be avoided because it considered as a deadly spiral from which nation can hardly recover.

Aggregate demand is simply the sum or total demand for products and services of the entire economy. It shows the relationship between the aggregate level of price and quantity demanded and output of the businesses, households, government and the rest of the world. Normally, it depicts the gross domestic product of the country or of the economy. Following is the graphical representation of aggregate demand curve.

The formula for aggregate demand is

AD = C + I + G + (X - M)

Where,

Consumption = C,
Investment = I,
Government Spending = G,
X = Exports &
M = Imports

Consequences of deflation in terms of Aggregate Demand

There are two main potential causes of deflation:

1. A fall in aggregate demand (AD)

2. A shift to the right of aggregate supply (AS) - i.e. lower costs of production through improved technology.

1. A fall in aggregate demand (AD)

Figure a: Deflation caused by falling aggregate demand (AD)

Here, in above figure, PL = Price Level, LRAS = Long-run aggregate supply curve, AD =Aggregate Demand, and Y = Real GDP. This simple AD/AS model shows that a fall in AD can cause a lower price level. Deflation usually occurs during a deep recession, when there is a sustained fall in demand and output.

2. A shift to the right of aggregate supply (AS)

Figure b: Deflation caused by lower costs

Here, in above figure, PL = Price Level, SRAS = Short-run aggregate supply curve, AD =Aggregate Demand, and Y = Real GDP. This is deflation caused by lower costs of production. This could be due to lower oil prices or improved technology, e.g. development of computer chips which enables price of manufactured goods to fall.

For instance; 1920s Japanese Deflection was the example for deflection, and the reasons are the massive injection of public funds by indemnifying against the losses of the central bank, and structural reforms in the banking sector through the promotion of bank amalgamation and other measures of that sort (Shizume, 2012).

References

Guell, Robert C. (2015). Issues in Economics Today , 7th edition- 2015 ISBN: 978-0078021817

Shizume, M. (2012). The Japanese economy during the interwar period: instability in the financial system and the impact of the world depression. In The Gold Standard Peripheries (pp. 211-228). Palgrave Macmillan, London.