Question

Use appropriate diagrams to explain graphically how an aggregate demand shock can lead to the economy entering a deflation trap. Does every permanent negative demand shock lead to a deflation trap? If not, show graphically an example of where a negative demand shock leads to a temporary deflation episode, but the economy does not fall into the trap (i.e. it goes to a medium run equilibrium). Draw the appropriate diagrams and briefly explain your reasoning.

Answer 1

A negetive demand shock is a situation of declining economy when aggregate demand curve shifts leftward and leads the economy towards recession and deflation.

AD<AS

This negetive demand shock may be temporary or permanent.

Permanent negetive demand shock and deflation trap

It is a worsoned condition of declining economy which leads to deflationary spiral

* Zero interest rate and still no investment leafs to liquidity trap

* Tight money supply

* Banks resist further lending dud to irrecoverable loans

* Lowering level of consumption expenditure

* Increased burden of debt

The graph below shows all this---------------

In the above graph, we find that economy has fallen into deflation trap, due to fall in price level and decrease in real GDP.

​Negetive demand shock and temporary deflation

A sudden and surprising event which leads to decrease in demand for goods and services on a temporary basis

Causes are------

*Natural disaster--- Recent pandamic covid-19, floods, earthquake, terrorist attack

* Contractionary Monetary and fiscal policy--- decrease in money supply and reduction in govt spending

* Trchnological advancement

See graph-----

We find in graph, AD and short run AS curves intersect at Equilibrium Point E but after the temporary demand shock, AD curve shifts leftward ( AD') and leads to decreased real gdp a(Y'') and fallen price level ( p').

But point to be noted that in case of temporary negetive demand shock, the effect on real gdp and prices will not persist fir a long time .In the long run, the real gdp gdp be equal to potential gdp(Y) and prices will be at Equilibrium level( p)

congratulations