Following a sharp collapse in consumer confidence and asset prices, household consumption has contracted significantly, leading to a severe drop in aggregate demand. With warehouses accumulating unsold inventories, firms find themselves with vast amounts of spare capacity and underutilised capital. To stimulate sales, businesses have begun cutting prices, triggering concerns of a persistent deflationary spiral. Furthermore, as labor demand falls, workers face diminished wage growth, and in some sectors, nominal wage cuts, further suppressing domestic demand and reinforcing downward pressure on the general price level. (Lines 1–6)
Based on Extract C, explain two reasons why a severe contraction in aggregate demand is likely to lead to disinflation or deflation in an economy.
