Deflationary gap

Deflationary gap is the shortfall in AD from the level required to maintain full employment equilibrium in the economy. In such a situation, there is involuntary unemployment in the economy.

When there is a situation of deficient demand, resources are not fully utilized and there is excess capacity in the economy. The economy moves towards deflation. as the aggregate demand is not sufficient to purchase the potential output, income, output and employment in the economy will fall. Due to excess supply and low demand, prices of commodities fall.

A situation of deflationary pressure emerges in the economy.

Deflationary pressure is proportionate to deficient demand i.e. deflationary gap is a measure of the amount of deficient demand in the economy. 

Greater the deficient demand, greater the deflationary pressure.

Below graph explains the deflationary gap

Deflationary gap

AD : Aggregate demand at full employment

AD₁: Underemployment Aggregate demand

AB: deficient demand = deflationary gap

OM: Full employment level of output

ON: equilibrium output owing to underemployment

AD is Full employment Aggregate Demand. The intersection of AD curve with 45^◦ line at A gives us the equilibrium corresponding to full employment level of output M.

Now, suppose aggregate demand curve shifts downwards to AD₁ due to say, decrease in government expenditure.

It is a situation of deficient demand. This will lead to a fall in income to ON, causing unemployment in the economy. As the aggregate demand is not sufficient to purchase the potential output, income, output and employment in the economy will fall.Due to excess supply and low demand, prices of commodities fall. 

Situation of deficient demand is described as a situation of deflationary gap in the economy.

Deflationary gap = Desired AD corresponding to full employment – Desired AD corresponding to underemployment = AB

Deflationary gap = Deficient demand = AD - AD₁ = AB