Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Deflation caused by falling aggregate demand
Explain how a fall in aggregate demand can lower both the price level and real GDP. Distinguish demand-side deflation from falling inflation.
The economic idea
Deflation is a sustained decrease in the general price level, measured by a negative rate of change in a broad price index. Disinflation is different: inflation remains positive, but the price level rises more slowly.
Demand-deficient deflation occurs when aggregate demand falls relative to the economy’s productive capacity. Firms experience weak sales, cut production and employment, and reduce prices or wages where possible.
Deflation can raise real debt burdens because debts are fixed in nominal terms, increase real interest rates when nominal rates cannot fall further, and encourage households to postpone spending if they expect lower future prices. These effects can weaken AD again and create a deflationary spiral.
The severity depends on expectations, indebtedness, banking conditions, wage flexibility, fiscal and monetary responses, and whether the fall in prices is temporary or sustained.
Reading the movement from AD₁ to AD₂
“Price level” measures the general price level and “Real GDP” measures real output.
“AD₁” is initial aggregate demand, “AD₂” is current aggregate demand and “SRAS” is unchanged.
“E₁” identifies “Pl₁” and “Y₁” before the change; “E₂” identifies “Pl₂” and “Y₂” afterwards.
Starting point: E₁
“E₁” is the initial macroeconomic equilibrium before the spending change.
The demand contraction
“AD₂” lies to the left of “AD₁”. The price level falls from “Pl₁” to “Pl₂”, while real GDP falls from “Y₁” to “Y₂”. The visible equilibrium movement is consistent with a fall in the general price level.
Interpret the output movement before evaluating deflation
The movement toward “E₂” combines a lower price level with weaker output. It is therefore associated with a recessionary process and rising cyclical unemployment.
Why falling prices can reinforce a demand slump
If households expect prices to fall further, some may postpone purchases. Lower spending can reduce firms’ sales, output and employment, weakening household income and consumption again.
Deflation also increases the real burden of a fixed nominal debt. These are possible reinforcing effects, not extra curve movements already proved by the diagram. State the conditions before adding them to an explanation.
From weak expenditure to a possible deflationary spiral
A fall in autonomous expenditure shifts aggregate demand from “AD₁” to “AD₂”.
At “Pl₁”, planned spending is below production, so inventories accumulate and firms cut output and prices.
The economy reaches “E₂”, with the changes shown by “Pl₂” and “Y₂”.
If expected price falls delay spending and raise real debt burdens, AD may weaken again, making deflation self-reinforcing.
Common mistakes to avoid
- A lower inflation rate is disinflation unless the general price level is actually falling.
- A fall in one product’s price is not economy-wide deflation.
- The fall in output is not caused by a shift of “SRAS”; it is movement along the unchanged supply curve after AD falls.
- The diagram shows a price-level change; a sustained deflation rate requires the process to continue over time.
How to draw this diagram
- Title the diagram “Deflation caused by falling aggregate demand”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD₁ first and label it clearly.
- Draw AD₂ next and label it clearly.
- Draw SRAS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- A static AD–AS diagram shows a change in the price level, not the duration required to establish deflation.
- A national price index may conceal different price changes across households and sectors.
- Expectations, debt contracts, banking stress and policy reactions are not represented directly.
- The model does not show the zero lower bound, balance sheets or feedback from defaults to bank lending.