Question

Illustrate graphically the notion of ‘deficient demand.’

Explain and illustrate diagrammatically the concept of deficient demand.

What happens to economy's output, income employment and price level when there is deficient demand?

Answer 1

In Figure, the aggregate expenditure curve AD₀ intersects the 45° line at E, yielding the equilibrium income OY_f. This is the income level associated with full employment. Assume government expenditure reduces, causing the new aggregate expenditure curve to shift to AD₁. At full employment income, the aggregate supply is either OY_f or EY_f. This exceeds the actual aggregate demand for AY_f. The insufficient 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 in the economy will decline. Thus, a lack of demand indicates underutilization of resources. Deficient demand causes prices to decline due to abundant supply. Thus, insufficient demand reduces the economy's income, output, employment, and prices, putting it into underemployment equilibrium. The underemployment equilibrium is the level of income that is smaller than the full employment level of income. In other words, insufficient demand has the potential for 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.