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After the inception of the global financial crisis, the level of output in the Australian economy declined. This led to the level of aggregate supply exceeding the level of aggregate demand as consumers’ and investors’ confidence was shaken. This is evident in the Keynesian diagram below:
Figure 1.8- Keynesian deflationary gap
As it is evident in the graphical representation above, the equilibrium level of national income is Ye, determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. If the full employment level of the economy’s income exceeds total spending, as it occurred as a result of the global downturn, it will cause a deflationary gap denoted by the interval CD. This causes inflationary pressures to decline and become less of a concern, leading to a lower price level.
Moreover, the government’s decision of increasing the size of its forecast Budget surplus has the effect of reducing demand-pull inflation. This is because when government revenue is increased (i.e. the budget surplus forecast) and spending is decreased, this will in turn reduce demand pressures in the economy, lessening demand-pull inflation. This is supported by the diagram below:
Figure 1.9- Keynesian deflationary gap
The diagram illustrates how a decrease in the Government’s future expenditure can reduce demand-pull inflation using the AD/ AS model of the economy. The economy’s equilibrium price and output is found where AD and AS intersect at price level P and real GDP₁, which is the full employment level of national income. If aggregate demand decreases from AD to AD₁ because of a rise in a budget surplus, the price level will decline to P₁, and the real GDP will decrease to real GDP₂, resulting in a deflationary gap of CD.
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"A Justification of the Use of Macroeconomic Policies." 123HelpMe.com. 18 Aug 2018
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Dixon, T 2009, Australia in the economy, Pearson Australia, Melbourne.