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Hello Sir. I hope you are doing good.
I had a confusion in Bpp. One of the following measures to deal with current account deficit :
“Domestic deflation to reduce aggregate demand in the domestic economy”
I thought it was supposed to be an increase in aggregate demand.
Thank you so much 🙂
Inflation can be caused when demand in the economy outstrips supply as that will push up prices.
If the government greatly increase interest rates, then aggregate demand would be cut as people could no longer afford to borrow to spend. This would decrease inflation and would eventually reverse this into deflation.
This has an indirect effect on the current account deficit (government borrowing) only because if prices fall the government does not have to pay as much to fund its activities.
What I can understand from this is:
When prices rise, demand starts to decrease gradually and this also seems to happen with interest rates as well since not everybody can afford to borrow at higher interest rates. So what the government does is reduce inflation and bring it to a level so that demand starts to rise again and they can try to achieve a balance once again.
But I’m still confused about the part where it says- domestic deflation reduces aggregate demand.
Also I am having a little trouble in relating the current account deficit with deflation.
Also thank you for replying 🙂
Just because the price of a product roses does not mean that there is inflation in an economy. Eg the price of potatoes might rise, but the price of rice might fall at the same time. Demand for potatoes will reduce and demand for rice will increase: this is just the normal operation of demand curves. However, a family’s food bill could remain constant and there might be no inflation in the economy.
Inflation is when prices in the economy are all (more or less) rising as are wage rates. With inflation, rising prices do not necessarily reduce demand because wages increase too. For example, when the Covid pandemic subsides (we hope) people will be in an optimistic mood and will have cash to spend that they saved during restrictions. Demand and rise and when demand cannot be met any further (eg everyone is employed) wage rates, hence prices will rise. This is inflation.
At the start of the pandemic deflation would have occurred if governments hadn’t pumped money into the economy to keep people buying. If fewer people were going out to spend money production would have outstripped demand and prices would have fallen….as would wage rates because fewer people would have been employed. Aggregate demand is the sum of buying activity in the economy and that would fall to.
Thank you so much for replying.
Oh so that means inflation happens when there’s price increase in “all” goods. That one I didn’t know in detail. Thank you for explaining. But that part still keeps confusing me that domestic deflation reduces aggregate demand. Probably I might have missed something what you explained.
Just think that inflation means prices and wages increasing. Aggregate demand (total demand for final goods) increases.
Deflation means the reverse.
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