Using real world examples, evaluate the claim that according to the Keynesian and classical/monetarist models a decrease in AD will always be deflationary.
Aggregate demand is the total output of an economy in a given period of time. It can be measured by summing up total consumption, total investment, total government expenditure and the trade balance (exports-imports). A reduction in AD will be a caused by a fall in one of the components of AD (C+I+G+(X-M)). A fall in AD implies negative economic growth and with that deflationary pressure. With the use of real-world examples, this essay will analyse the mechanism by which a fall in AD causes deflationary pressure in an economy, whilst also evaluating why this may sometimes not be the case.
When AD falls, we usually assume that there is a drop in both consumer and business confidence resulting in a reduction in both consumption (C) and investment (I). As a result, demand in general falls throughout the economy and there will be less spending. As individuals and businesses spend less money, firms will respond by reducing output, which could potentially lead to job loss. The reduction in economic activity leads to deflationary pressure as businesses may scramble to keep themselves afloat by lowering prices to encourage purchases. This can be show on the monetarist diagram below:
As AD shifts inwards there is deflationary pressure as price decreases from P to P1. As a result, real output also falls from Yf to Y1 creating a deflationary gap. This phenomenon is currently being experienced by the Chinese economy. The Chinese post-covid recovery has been quite slow and aggregate demand has not picked up as quickly as expected. Weak levels of AD in the Chinese economy are thus causing deflationary pressure. This has predominantly been caused by overcapacity in the industrial sector and a weak outlook for the Chinese real estate market which in recent months has seen many major developers default on loans. The property sector has long been very buoyant in China with prices skyrocketing, especially in major cities like China. The weak demand and low levels of consumer confidence are now pushing prices down though. According to the monetarist model, the economy would self-correct and SRAS would shift outwards in response to the lower costs of production for firms. If this was the case, the long-run output would be restored at Yf but with even further deflationary pressure.
A fall in AD and the consequent deflationary pressure may not always be a bad thing though. If the AD curve was placed to the right of the original AD curve above, the economy would have been overheating by producing beyond the full employment level of output. In that case a fall in AD would be deflationary in nature but actually enable the economy to return to its long run equilibrium and ensure sustainable growth and development.
The Keynesian model can also be used to show how a fall in AD is deflationary in nature. In the Keynesian model there is no difference between short run and long run aggregate supply as Keynes did not believe that an economy would necessarily always be able to operate at the full employment level of output in the long run.
The diagram below shows a decrease in AD would also cause deflationary pressure with P1 falling to P2 and Y1 falling to Y2, creating the deflationary gap between Y2 and Y1. The fall in AD in this case could also have been caused by a variety of factors affecting any of the components of AD.
Whilst this diagram could also be used to show how falling AD is causing deflationary pressure in the Chinese economy as described above, it is important to note that there are times when a fall in AD does not cause any deflationary pressure and we can use the Keynesian model to show this. The diagram below also shows a decrease in AD. However, in this case the shift does not cause any deflationary pressure, only a reduction in real output. This is because the economy is already experiencing very low levels of AD and is most likely in a recession. Keynes argued that when an economy is in a deep recession, it will struggle to return to the full-employment level of output and may remain stagnant for a long time without any government intervention. This is the horizontal part of the AS curve, where prices remain sticky as factors of production are so abundant they do not respond to any changes in AD.
This could also be the case when an economy is suffering from a combined affect of low AD and high cost-push inflation. This has been the case in the United Kingdom for the last 2 years where AD has been very low but there has not been any deflationary pressure. On the contrary, due to surging energy prices across Europe, the economy has had persistent levels of very high inflation and despite government measures to dampen AD further, such as increasing the interest rate, inflation has remained and the decrease in AD has not been deflationary as intended.
In conclusion, a decrease in AD will not always be deflationary. It very much depends on the state of the economy and current levels of business and consumer confidence. AD falling might not lead to any deflationary pressure if the economy is already in a recession or experiencing high levels of cost-push inflationary pressure. Only the Keynesian AS/AD model is able to show this though as any decrease in AD in the monetarist model will always lead to deflationary pressure.