Chapter 12: Problem 5

Explain how a change in aggregate demand and aggregate supply can cause deflation.

Short Answer

Expert verified

Deflation can be caused by a decrease in aggregate demand or an increase in aggregate supply. When aggregate demand decreases, less demand for goods and services leads to lower prices, which is deflation. Similarly, when aggregate supply increases without a corresponding increase in demand, the surplus goods lead to lower prices, causing deflation.

Step by step solution

Defining Deflation

Deflation is a decrease in the general price level of goods and services. It happens when the inflation rate falls below 0%. In the state of deflation, the purchasing power of money increases, allowing consumers to buy more goods and services with the same amount of money.

Understanding Aggregate Demand and Supply

Aggregate demand is the total demand for all goods and services in an economy. It is influenced by factors like consumer spending, investment, government spending, and net exports. Aggregate supply, on the other hand, is the total supply of goods and services produced within an economy at a given overall price level. It is impacted by production costs, labor costs, and technological progress.

The Interaction Between Demand and Supply

In a balanced economy, aggregate demand equals aggregate supply. Changes in either demand or supply can lead to price changes. If demand increases faster than supply, prices often rise (inflation). If supply increases faster than demand, or demand decreases, prices often fall (deflation).

Effect of Change in Aggregate Demand and Supply on Deflation

A decrease in aggregate demand can lead to deflation. This is because less demand for goods and services leads to lower prices, as sellers compete for fewer buyers. An increase in aggregate supply can also lead to deflation. This is because more goods and services are available, but if demand doesn't increase at the same pace, sellers need to lower prices to sell the surplus goods.

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