Question

Question 6 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. [Word limit = 250 words]

Answer 1

During negative demand shock, aggregate demand is decreased due to reduced consumption preferences and thus the prices too fall causing deflation in short run.

If this continues for long time economy enters deflation trap as it cannot fome out.

However if an expansionary fiscal policy and expansionary monetary policy is implemented the economy recovers and inflation rises causing deflation trap to eliminate and economic growth is stabilised.

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