What is deflationary gap?

A deflationary gap is the extent to which potential output or income exceeds

the aggregate demand.

When the actual national income is below that of the full employment level, it
means that the investment opportunities are not enough to utilize all the
savings that will be available if national income is to be maintained at full
employment level. In such a case, there exists a situation that is known as a
deflationary gap. In general we say it is when aggregate demand is less than
aggregate supply, (AD<AS).

It is measured by the excess of savings over investment or by the difference

between incomes at equilibrium level and at full employment level. It can be
shown in a diagram as shown below in Fig.1

With the diagram above, it is evident that there is under utilization of

resources. Unemployment occurs when the equilibrium level of national 0Ye is
below the full employment level 0Yf as shown in Fig 1, income at equilibrium
point, 0Ye, is lower than that at the full employment level, 0Yf, putting forward
the idea of resources that are lying idle or unemployed and as a result of this,
the economy suffers from dead-weight loss, thus the income lost by the public
and not gained by anyone else. With unemployment being reflected, output is
as well reduced thus the living standards in the prevailing country will be
lowered.

We can also use the equation: Y*(potential GDP)-Y (actual GDP) = Output gap
(GDP gap)

If the output gap is positive, then we have a recessionary gap. For example, our
potential GDP may be $5bn and the actual GDP may be $4bn, we get a positive
output gap of $1bn positive output gap which is recessionary gap or the
deflationary gap.

The injections-withdrawals approach can also be used.

The deflationary gap, as shown above would be one below point e. Because of
this, the economy will face a fall in investment accompanied by business
closures leading to increase in unemployment and a decrease in the nation
output levels and price wars caused by competition between firms when trying
to sell all of their output to few customers.

What is inflationary gap?

An Inflationary gap is the extent to which aggregate demand exceeds the
national income at full employment level. It can be a situation where aggregate
demand made up of household expenditure, investment by firms,
government expenditure and net exports exceeds aggregate supply of the
economy at full employment.

An inflationary gap is denoted by the gap as shown in the diagram above.

When aggregate demand exceeds the national income, a shortage develops of
commodities in the economy which causes prices to move upwards to a point
of equilibrium e, where aggregate demand = national income or output.
Inflationary pressures build up causing the currency to lose its value or its
purchasing power. This makes imports expensive and it greatly affects local
companies in production which use imported raw materials. Some workers
may be laid off work causing unemployment to go up.

Another cause of an inflationary gap could be the objective of an export

surplus which generates domestic income but no subsequent increase in
aggregate supply. When injections are greater than leakages, there is an
inflationary gap created.

Compiled by Nicholas M Tembo