Answers may include: Definition

• Inflation: A sustained increase in the average price level of goods and services in an economy over a period of time.
• Aggregate Demand (AD): The total spending on goods and services in an economy at a given price level and in a given time period, composed of consumption, investment, government spending, and net exports.

Explanation / Economic Theory

• Demand-pull inflation causes increases in aggregate demand
• Aggregate demand may increase due to factors such as higher consumer confidence, increased investment, expansionary fiscal or monetary policies, or a rise in exports.
• An outward shift of AD from AD₁ to AD₂ in the short run leads to a new equilibrium with a higher price level (from P₁ to P₂) and higher real output (from Y₁ to Y₂).
• The short-run aggregate supply (SRAS) curve is upward sloping, meaning that when AD increases, the economy moves up along the SRAS curve to a higher price level.
• Higher real output in the short run can lead to reduced cyclical unemployment because firms employ more resources to meet the increased demand.
• Rising price levels reduce the purchasing power of money if wages do not increase in line with inflation, potentially decreasing real incomes for some households.
• A continued increase in AD can cause persistent demand-pull inflation. If the economy approaches or reaches full employment, resources become scarce, further accelerating price increases.
• Cost push inflation is caused by increases in SRAS. These include factors such as firms' production costs.
  • Common causes include rising wages, increased prices of raw materials, and higher taxes on production.

Diagram

• Two diagrams; one for demand-pull inflation and one for cost-push inflation

Answers may include: Definition

• Deflation: A persistent fall in the average price level of goods and services in an economy over a period of time.
• Inflation: A sustained increase in the average price level of goods and services in an economy over a period of time.
• Aggregate Demand (AD): The total spending on goods and services in an economy at a given price level and in a given time period, composed of consumption, investment, government spending, and net exports.

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Explanation/Economic Theory

• Deflation occurs when there is a decrease in the general price level. This can be caused by a leftward shift of the AD curve (a drop in aggregate demand) or a rightward shift of the aggregate supply curve (an increase in total output capacity).
• Demand-driven (bad) deflation:
  • Lower AD reduces real output (GDP) and places downward pressure on the price level.
  • Decreased confidence leads to lower consumption and investment, intensifying economic contraction.
  • Firms may reduce output, leading to higher unemployment and underutilized resources.
  • Debt burdens can rise in real terms (due to lower nominal incomes), which can further dampen spending.
• Supply-driven (potentially beneficial) deflation:
  • An increase in aggregate supply (e.g., due to technology improvements, higher productivity) can reduce price levels while increasing real output.
  • Consumers can purchase more goods and services with the same income.
  • There is potential for greater economic efficiency and higher standards of living.
  • However, if deflation persists, there is a risk that consumers and firms postpone spending and investment in anticipation of even lower prices.
• Key considerations:
  • Deflation can increase the real value of money but can discourage consumption and investment if it is linked to reduced economic activity.
  • The overall effect on stakeholders (consumers, producers, government) depends on whether deflation is demand-driven or supply-driven and on how prolonged it becomes.

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Diagram

• An AD/AS model can illustrate how a sustained decrease in AD shifts the AD curve left (leading to lower price level and reduced real output) or how a rightward shift in the aggregate supply (AS) curve can lead to a lower price level but a higher or stable real output.
• Annotation could show:
  • Original equilibrium at P₁, Q₁.
  • New equilibrium at P₂ < P₁ (a lower average price level).
  • Depending on the shift (AD left or AS right), Q₂ may be lower (in demand-driven deflation) or higher (in supply-driven deflation) than Q₁.

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Evaluation

• Short-run vs. long-run impacts:

  • In the short run, demand-driven deflation can increase unemployment and decrease output, reducing incomes and consumer confidence.
  • In the long run, persistent deflation can discourage spending, delay investment, and exacerbate debt burdens. However, supply-driven deflation may boost efficiency and output if fueled by productivity gains.

• Real-world examples:

  • Japan experienced sustained deflation from the early 2000s, with average inflation rates hovering around zero or slightly negative (e.g., -0.3% in certain years). This prolonged deflation was largely associated with weak consumer demand, high savings rates, and rising real debt burdens, contributing to slow growth.
  • The Eurozone faced periods of near-zero or negative inflation between 2014 and 2016 (for instance, an annual inflation rate of -0.1% in 2015), prompting worries about reduced consumer spending and stalled economic recovery. Monetary policy efforts by the European Central Bank, including low or negative interest rates, were aimed at avoiding a deeper deflationary spiral.
  • In contrast, deflation driven by technological advancements in the electronics and communication sectors after 2000 reduced prices of products such as smartphones and computers. This supply-side deflation benefited consumers through more affordable goods while stimulating new forms of spending in other sectors.
  • In several emerging economies, improvements in productivity for manufactured goods have intermittently led to lower prices domestically. However, these episodes did not always produce harmful effects if overall demand remained robust.

Conclusion

• Although deflation is often associated with adverse consequences such as falling real output and rising unemployment (particularly when linked to a fall in aggregate demand), it is not always undesirable.
• When deflation results from stronger productivity and technological advancements, it can align with higher output and rising real incomes, indicating a potentially positive outcome.
• The view that deflation is always undesirable is thus not fully accurate, as its impact on an economy depends on underlying causes, the extent of the price level decline, and how long deflation persists.