Policies to correct deflation
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The effect of an effective expansionary fiscal policy or monetary policy is shown in a diagram.
Initially, there is deflation and low levels of economic activity. The aggregate demand curve is represented by AD and the price level is at P.
An increase in government spending...
A cut in tax rates...
An increase in money supply...
A cut in interest rates ...
...will stimulate the economy. This will shift the aggregate demand curve outwards from AD to AD1.
The price level will increase from P to P1. Consequently, the level of deflation is reduced.