Inflationary and Deflationary Gaps:

J. M. Keynes in his famous book 'General Theory' put forward an analysis of unemployment and inflation. The Keynesian theory assumes that a maximum level of national output can be obtained at any particular time in the economy. According to him the maximum level of national income is generally referred to as full employment level of national income. If the equilibrium level of national income coincides with the full employment, there will be no deficiency of aggregate demand and hence no dis-equilibrium unemployment (seasonal, frictional unemployment can exist at this level).

Now if the equilibrium level of income as determined by the AD (aggregate demand) and AS (aggregate supply) is not equal to the level of full employment, then two situations can arise. Either this equilibrium level will be below the full employment level or above the lull employment level. In case, the equilibrium income is below the potential income, it indicates the presence of recessionary gap. If it is above the full employment income, it shows the presence of inflationary gap. Both the situations of deflationary and inflationary gaps are situations of disequilibrium in the economy. These gaps are now explained with the help of graphs.

Deflationary gap is also called re-cessionary gap. When there is an insufficient demand for goods and services in the economy, the equilibrium will occur at the lower level of full employment income and to the left of full employment line. In other words, re-cessionary gap occurs when the aggregate demand is not sufficient to create conditions of full employment.

The deflationary gap thus is the difference of amount by which aggregate expenditure falls short of the level needed to generate equilibrium national income at full employment without inflation.

Example and Diagram/Figure:

The deflationary gap is illustrated in figure below:

In this diagram 31.4, the national income is measured on OX axis and aggregate expenditure on OY axis. Let us assume initially that the aggregate expenditure curves AE° interests the 45 degree line at point E^/ to the left of full employment line or potential income.

The economy is operating at equilibrium income level of $150 billion which is below potential income of $250 billion. There is a deficiency of $100 billion in aggregate expenditures. This shortfall of national expenditure ($100 billion) below the potential income or the full employment level of national income is called Re-cessionary Gap.

When the economy is operating below its potential income, the government recognizes the re-cessionary gap in aggregate income. It increases its expenditures to stimulate the economy. The multiplier process takes over. The increase in government expenditure shifts the AE^/ curve from AE° to AE¹ increasing aggregate income to the full employment income level. Such government action is expansionary fiscal policy.

Deflationary gap thus represents the difference between the actual aggregate demand and the aggregate demand which is required to establish the equilibrium at full employment level of Income.

An inflationary gap is just the opposite of deflationary gap. It is said to exist when equilibrium income exceeds full employment income. It is created due to the effective demand being in excess of the full employment level. It is the difference between equilibrium income and full employment income (potential income) when equilibrium income exceeds the full employment income. Here people are trying to buy more goods and services than can be produced when all resources are fully employed. There is too much money chasing too few goods. The result is that the excess demand pulls up prices and there is inflation. The excess demand for goods and services is being met in money terms but not real, terms.

Example and Diagram/Figure:

An inflationary gap is explained with the help of figure below:

In this figure 31.5 aggregate expenditure curve AE° intersects the aggregate production curve (45 degree helping line) at point E^/ to the right of potential line or full employment line (FE).

The equilibrium level of income is $200 billion whereas the potential income is $100 billion. When the equilibrium income exceeds potential income, there is said to be inflationary gap which in the diagram is $100 billion. The excess expenditure of $100 billion causes upward pressure on prices when there is no additional output produced.

Whenever there is an inflationary gap in the economy, the government adopts deflationary fiscal policy of lowering government expenditure or raising taxes. It also adopts deflationary monetary policy for reducing the amount of money in the economy.

(i) When equilibrium income is below its potential income level, the difference is called deflationary gap. The government can increase its expenditure to stimulate the economy.