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Lesson 21: Causes of Demand & Supply Side Inflation

Module 1: Macro Fundamental Analysis

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Video Transcript

in this lesson we’re going to look at demand side deflation now demand side deflation is what all central banks and governments want to avoid and it can be very very dangerous if we get into a deflationary spiral scenario so demand side deflation when the aggregate demand curve shifts to the left so if we take our original equilibrium point here you can see where the ad1 curve intersects with the sras curve we have an output here of roughly speaking 700 in terms of real gdp that could be 700 billion dollars and to the left on the y-axis

we have a price level so the average price of goods and services within this economy at about 70. now when the ad curve shifts to the left we get a new equilibrium point right here and you can see our output has decreased from roughly 700 to about 550 and if we take this over to the y-axis you can see prices have fallen from about 70 to about 50. it’s this decrease in the average level of prices of goods and services within the economy which is demand side deflation and this comes with that contraction in gdp so demand side deflation occurs when the aggregate demand curve shifts to the left inflation decreases and even turns negative so inflation becomes negative deflation and real gdp decreases there’s a contraction in real gdp and this is deflation now what can cause a shift to the left in the aggregate demand curve well causes of demand side deflation are a decrease in consumption now what could cause a decrease in consumption in an economy well consumer confidence could decrease there could be a rise in interest rates there could be a rise in income tax or any taxes associated with the consumer investment could decrease there could be a decrease in business confidence which caused a reduction in investment so the i part of the c plus i plus g plus nx aggregate demand formula interest rates again could rise this would also disincentivize investment from businesses as they would be less prepared to take out loans at higher and higher interest rates so investment would decrease an increase in corporation tax or taxes associated with businesses would eat into a company’s retained profits and therefore investment would also decrease government spending could decrease so if the government is spending 100 billion dollars in a year on infrastructure projects and it reduces that to 50 billion dollars this is going to be deflationary for the economy this is going to shift the aggregate demand curve to the left and net exports could also decrease so we could have a devaluation in the nx part of the formula here and that could be because of an increase in the exchange rate so if the exchange rate increases if the currency appreciates in value in this economy exports will become less competitive and this would see a decrease ceteris paribus in net exports so this type of deflation is known as malignant deflation this is bad for the economy and this is probably the worst scenario out of all of the economic conditions that can take place and this is why governments and central banks will enact monetary and fiscal policy measures at the bottom of the business cycle to shift a.d back to the right to stimulate economic growth and inflation and to stop a deflationary spiral so what is a deflationary spiral well deflationary spirals tend to be long lasting and they are self-fulfilling prophecies they get worse and worse because further falls in prices are anticipated so consumers for example will see something that they want they see prices are coming down and rather than purchase now they will wait they will delay their spending in order to get a better future price and this can cause this delay in spending can actually cause further decreases in consumption further decreases in investments and further decreases in spending on net exports and all of this is going to cause a worsening situation creating more and more deflation in the economy you also have in a deflationary spiral saving incentivized by a rising real interest rate so it’s that terminology again interest rates adjusted for inflation so if you have an interest rate of two percent in an economy and the inflation rate is minus two percent because you have deflation so the average level of prices of goods and services has declined by two percent then in order to adjust for inflation you would take the initial interest rate and you would minus from this the inflation rate and that gives you your real interest rate so you can see two percent minus minus two percent and when you have a positive number minus a negative number this will actually give you the same as if you had two positive numbers so this would be four percent so two percent minus minus two percent gives you four percent so in real terms adjusted for inflation interest rates have gone up now what does this actually mean well what it simply means is that if you have your money in the bank and you are being paid two percent as an interest rate on your savings and there is an inflation rate of two percent in the economy you haven’t in real terms really gained any purchasing power because you have two percent extra money but everything else in the economy has gone up by two percent as well so really you’re in the same position in terms of purchasing power as you were the previous year let’s say now if you have a two percent interest rate on your savings and there was no inflation or deflation this was zero your real purchasing power would actually increase by two percent because now you have two percent more money than you did say the year before and all of the goods and services within the economy are the same price as they were last year so your purchasing power has gone up by two percent if however you have your money in the bank and there is an interest rate of two percent and at the same time prices of goods and services in the economy declined by two percent as well not only do you have an increase in your purchasing power of two percent from the interest you’ve gained but you have another increase in your purchasing power of two percent because prices of goods and services in the economy have decreased so your purchasing power has gone up so when this takes place people are incentivized to leave their money in the bank they will save their money because in real terms as they are holding cash and the general level of prices of goods and services within the economy are coming down that cash is generating more and more purchasing power and saving being incentivized within the economy is the same as a delay in spending or a reduction in spending because you can either do two things with your money you can consume with it you can spend it or you can save it so if people are saving they won’t be spending so saving being incentivized within the economy actually reduces spending even further and once again causes a worsening deflationary situation and this self-perpetuating decline in prices where this situation feeds on itself and gets worse and worse is known as a deflationary spiral now let’s look at supply side deflation so deflation which occurs from factors affecting the supply side so supply side deflation is caused by a shift to the right of the sra sras curve and this is an increase in aggregate supply along all price levels and as you can see when we have a shift to the right in short run aggregate supply we have a decrease in inflation and an increase in real gdp and this can be seen if we take our initial equilibrium point here and we go across to the y axis you can see we have roughly an average level of prices of goods and service within the economy at about 70 dollars just over and if we come down from our initial equilibrium point you can see we have roughly an output of about 450. when the sres curve shifts to the right we have a new equilibrium point here and if we shift this out to the y axis you can see we have now a lower average level of prices of goods and services within the economy and at the same time we have an increase in real gdp so inflation decreases you get deflation this is supply side deflation and real gdp increases this is known as benign deflation this is actually considered to be quite good because unlike deflation from the demand side instead of a contraction in real gdp we actually have an expansion in economic growth so what factors would shift the short run aggregate supply to the right well this would be the cost of production decreasing so wages rents contracts coming down this would shift aggregate supply to the right corporation taxes or any taxes associated with businesses a decrease in these taxes would lead to higher retained profits and this would shift aggregate supply to the right the price of raw materials so commodities so input prices coming down this would also shift short-run aggregate supply to the right and if there was an increase in the exchange rate so a stronger currency would increase the purchasing power so it’s very similar to the price of raw materials decreasing the cost of raw materials would decrease because you can now purchase more of those raw materials for the same amount of money just bear in mind however we know that with a stronger exchange rate we would also maybe have a little bit of negative feedback in the net exports in terms of real gdp so we would have real gdp increasing but this would a stronger exchange rate would also have a slight negative impact on the trade balance so the characteristics generally speaking of supply-side deflation is that it’s short-term so it’s not in the same way as when prices are declining from the demand side consumers are delaying their spending to get better and better prices if the cost of input prices or raw materials declines for whatever reason it is not generally expected for this to just continue forever it’s expected most of the time that this will be short-term and there will be a rebound in the price of raw materials if the exchange rate increases for whatever reason it is generally expected that this may be short-term and that the exchange rate could very well in the near future revert back down to a weaker value so there are cases where demand side deflation could actually end up being short-term and there are cases where supply side deflation could be a little bit longer term but generally speaking the assumption is made that deflation caused by a reduction in the cost of production for businesses is generally speaking short term and there is not as much of an anticipation of a continuous fall in prices and so it doesn’t have that downward spiral that demand side deflation has at the same time as well profits and outputs have actually increased and as profits increase as real gdp increases unemployment will also decline and more people are in work companies are now making more profits and as a result both consumption and investment will increase so this is why we see that increase in real gdp and this is why this is known as benign deflation compared to that potential deflationary spiral on the demand side