Impact of Deflation | A-Level Economics Model Paragraph (AQA, Edexcel, OCR)

Deflation is a fall in average price level. This has a negative impact on the economy. If prices are constantly falling each month, consumers would delay spending on big purchases (cars/ TVs) as they expect cheaper prices in the future. Then, the same next month. AD = C + I + G + (X-M). Since consumer spending (C) falls and is a factor of aggregate demand (AD), the aggregate demand curve will shift to the left. This causes a fall in real GDP from y1 to y2.

AD LEFT SHIFT DIAGRAM

The diagram above shows that real GDP falls from y1 to y2 and the price level could fall even further from PL1 to PL2.

The fall in real GDP can mean that people lose their jobs as demand for labour is derived from the demand for goods and services. This is dangerous as it can lead to a deflation spiral and continuous left shifts in the AD curve. If real GDP continues to fall for two consecutive quarters, the economy would enter a recession. In a recession, the government may have to spend more on welfare payments, such as unemployment benefits, and the government would collect lower revenue from income tax, corporation tax, and indirect taxes (VAT).