Question

Distinguish between inflationary gap and deflationary gap. Show deflationary gap on a diagram. Can this gap exist at equilibrium level of income? Explain.

Answer 1

Excess demand or inflationary gap is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy. It implies two things-

1) Planned aggregate demand in the economy happens to exceed its full employment level.

2) The level of aggregate demand surpasses the level of aggregate supply even when the available factors are fully utilized.

Deficient demand or deflationary gap refers to the situation when aggregate demand is short of aggregate supply corresponding. Aggregate supply being perfectly elastic, it converges with aggregate demand at a lower level of output lower than the full employment level of output in the economy. This is a situation of underemployment equilibrium.

The diagram AB represents the deflationary gap or deficient demand.