Question

a) What does cause deflation during a recession and inflation when the economy is overheating? b) With shutting down nonessential businesses, explain how can inflation happen in words and graphs using the AD-AS model (Aggregate Demand/Aggregate Supply) (100 words)

Answer 1

Factors causing Deflation during Recession:

- Less Money in Circulation: If less money is circulated in the economy, then this will reduce the purchasing power of the public. They will start spending less and the aggregate demand will reduce. Consequently, due to less demand the price will fall and economy faces deflation.

- Excess Supply of Goods: Lack of demand and increased stock of goods in the warehouses put a downward pressure on the price. The producers have to reduce the price in order to sell them to the consumers. Hence, deflation occurs

- Negative Output Gap: This occurs when Actual Outpu < Potential Output. Low level of output will cause a downward pressure on the price.

- Significant fall int he wage rates is also a factor that contributes to deflation.

- Technological advances is a supply side factor that causes deflation

Factors causing Deflation during Recession:

- Increase in money supply would raise the purchasing power of the people. They will start demanding more goods. The AD will increase putting upward pressure on the price.

- Higher wages raises the firm's cost of production. This is also contributing factor towards inflation

- Currency Devaluation will increase the exports of the nation. Inflow of foreign currency in the nation will raise the domestic prices of goods and services

- Interest rate cut: this lead to higher amount of borrowing from the banks. People will start spending more and the increased demand will raise the general price level.

Below diagram shows the AD - AS Curves. Intitally economy is at equilibrium at point E.

Shutting down of non-essential businesses will create the stock of such goods in the godown known as excess supply of goods. With lack of demand and high supply, the prices of essential goods will rise as people would be willing to purchase the items at higher prices. This would cause inflation which is shown by the rightward shift in the aggregate demand curve from AD to AD1

(More than 300 words)

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