Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Deflation caused by increasing SRAS
Show how increasing short-run aggregate supply can lower the price level while raising real GDP. Contrast supply-side and demand-side deflation.
The economic idea
Deflation is a sustained decrease in the general price level. It is not the same as disinflation, in which prices continue to rise but at a slower rate.
Supply-led deflation occurs when productive efficiency improves or input costs fall, increasing short-run aggregate supply. Firms can profitably produce more at each price level, so the equilibrium price level falls while real output rises.
Possible causes include productivity growth, cheaper energy or imported inputs, improved supply chains and stronger competition. If the improvement also expands productive capacity, LRAS may shift right as well, though this diagram isolates the short-run supply movement.
Supply-led deflation is less likely than demand-deficient deflation to produce recession. Real incomes may rise and output may expand, although indebted borrowers can still face higher real debt burdens.
Reading the movement from SRAS₁ to SRAS₂
“Price level” measures the general price level and “Real GDP” measures real output.
“SRAS₁” is initial short-run aggregate supply, “SRAS₂” is current supply and “AD” 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 supply change.
The favourable supply shift
“SRAS₂” lies to the right/below “SRAS₁”. The price level falls from “Pl₁” to “Pl₂”, while real GDP rises 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 stronger output. It is therefore a favourable supply-side process rather than evidence of deficient spending.
A falling price level need not mean a demand crisis
Lower unit costs or higher productivity can allow firms to produce more at lower prices. That supply-led combination differs from falling prices caused by weak expenditure and falling real output.
Identify the source of the price fall before judging its effects. Consumers may gain purchasing power and firms may remain profitable after a cost improvement, although falling prices can still affect debtors and expectations.
From lower unit costs to supply-led deflation
Lower unit costs or higher productivity shift short-run aggregate supply from “SRAS₁” to “SRAS₂”.
At “Pl₁”, firms are willing to supply more than planned expenditure, placing downward pressure on prices.
The economy moves along “AD” to “E₂”, where the new price level and output are shown by “Pl₂” and “Y₂”.
If the productivity gain is lasting, productive capacity may also expand, but that further LRAS effect must be shown separately.
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 rise in output is not caused by a shift of “AD”; it is movement along unchanged AD after SRAS increases.
- 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 increasing SRAS”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS₁ next and label it clearly.
- Draw SRAS₂ 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 establish whether a short-run cost reduction also raises long-run productive capacity.