Question

Explain and show graphically the concept of deflationary gap.

Explain with the help of a diagram the concept of deficient demand using of aggregate demand and aggregate supply curves.

Explain the concept of deflationary gap with the help of suitable diagram.

Explain the concept of deficient demand with the help of aggregate demand and aggregate supply curves.

Explain the concept of deflationary gap with the help of a diagram.

Answer 1

In Fig., the aggregate expenditure curve AD₀ intersects the 45° line at E, which gives us the equilibrium income OY_f. This is the full employment level of income. Now, suppose government expenditure falls, as a result of which the new aggregate expenditure curve shifts to AD₁. At the full employment level of income, the aggregate supply is OY_f or EY_f. This exceeds the actual aggregate demand for AY_f. The deficient demand at the full employment income level is EA.

When demand is weak, the economy cannot be in equilibrium at full employment. The lack of demand will cause a drop in output and income to OY₁ (below full employment), resulting in unemployment in the economy. Because aggregate demand is insufficient to purchase potential output, producers in the economy would prefer to create less. As a result, income, output, and employment will decline. Thus, a lack of demand indicates underutilisation of resources. Deficient demand causes prices to decline due to an abundant supply. Thus, insufficient demand reduces the economy's income, output, employment, and prices, putting it into an underemployment equilibrium. The underemployment equilibrium is the level of income below the full-employment level. In other words, insufficient demand can lead to deflation. This is why insufficient demand (or gap) is referred to as the ‘deflationary gap’. Deflationary demand occurs when aggregate supply exceeds aggregate demand at full employment. The deflationary gap is the difference between actual aggregate demand and the level of aggregate demand required to achieve equilibrium at full employment income.

Answer 2

The deflationary gap is the difference between actual AD and AS at the level of full employment. In other words, it is the gap by which actual aggregate demand falls short of the aggregate demand required to fund a full-employment equilibrium.