Deflationary Growth

For simplicity, we suppose that the Long Run Aggregate Supply line shifts to the right while aggregate demand is unchanged. This is shown in the diagram below.

Figure Five: Deflationary Growth

We see the earlier LAS curve, LAS₁, in dark red and the later LAS curve, LAS₂, in lighter red. The NAIRGDP increases from Y₁ to Y₂. Aggregate Demand is the green curve labeled AD. We see that the equilibrium price level at the earlier period is p₁, while at the later period it is p₂. The price level has fallen as growth proceeds. And that will hold true in general: If the supply capacity of the economy increases through economic growth, while Aggregate Demand remains unchanged, the price level must decline steadily.

This picture of deflationary growth may seem unrealistic to people living in the nineties, who have lived most or all of their lives with inflation. However, it probably is a realistic picture of the 1800's, when the general trend of price levels in peacetime was downward.

All the same, there is no good reason for price levels to fall, and most economists would probably regard "balanced growth" as the ideal.

Balanced Growth