Inflationary and Deflationary Gaps, Definition and Graph

Sat, 06/30/2012 - 01:13 -- Umar Farooq

Inflationary and Deflationary Gaps

In a two sector economy where there are firms and personals doing certain kind of economic transaction between each other the equilibrium occurs where C + I equals S + C or aggregate demand of the economy equals the aggregate supply of the economy and if this happens to be at a level of income which represents full employment in the economy, it can only be regarded as blessing because it the best situation which can exist in the economy at any time. Still, it is not necessary that equilibrium level of income always represents full employment level of output and ser­vices. It can either be above it or can be below it. Then these situations are termed as gaps in the economy.

What is Inflationary Gap Definition

When the economy is operating at a level which is greater than full employment it is called inflationary gap and counter part of this case is known as deflationary gap.

Inflationary Gap Graph

inflationary and deflationary gap

In the diagram line OY shows the different level income in the economy it is a 45° line because national income can be calculated through product approach or through income approach and it will give a same financial figure line C + I shows the aggregated demand of the economy at point A this line is intersecting income line so it shows the equilibrium in the econo­my which also happens to be at full employment OYf. If the aggregate demand is such that the level of income as OYi or point B which is above the full employment level then the distance AB shows the inflationary pressure in the economy and if the actual level income is OYd is below the full employment level.

What is Deflationary Gap Definition

When the national income is below the full employment level it means the investment opportunities are not enough to utilize all the saving that will be available if N.Y is to be maintained at full employment in such a case there exists a situation known as deflationary gap also known as recessionary gap.

Deflationary gap is mea­sured by the excess of saving over investment or by the difference of income levels at equilibrium and at full employment. An inflationary gap rises when saving falls short of the total investment of the economy or the excess of equilibrium level of income over the full employment level of income, after full employment is reached the physical output cannot be increased so whatever may be the increase in income it is an increase in the financial value of the existing products.

Also Read:     Detailed Note on Inflation            What is Stagflation       Indifference Curve Analysis

Deflationary Gap Graph

In the above diagram full employment level of income is M = 2200 million at income level N = 1400 million there is equilibrium but this is not at all employment or C + I is less than C + S as it is compared at equilibrium, so expenditure must increase by 800 to reach full employment level of income if the value of the multiplier is four their just an increase of 200 million in invest­ment expenditure should be suffice to reach the full employment level and bridge the deflationary gap. If the existing level of income is represented by Rs. 3000 million of N, there is an excess of Rs. 800 million over full employment so now there must be contraction in the level of income and again the multiplier is four a fall of 200 million in the expenditure would be sufficient to regain the full employment level of income, a deflationary gap represents a deficiency of expenditure and an inflationary gap represents a deficiency of expenditure and an inflationary gap shows an excess of expenditure over full employment level of income.

Under these circumstances an agency is required to stabilize the economy's income level at or near full employment level. If the economy is facing the deflationary gap then it is the first objective of the fiscal or monetary agent the government to increase the level of income to full employment. Under monetary policy government can do it either by increasing money supply or by reducing the rate of interest in the former case the expenditure and ultimately the aggregate demand of the economy. A deflationary gap is a situation where the saving exceeds the existing level of investment so in the later case a reduction in the rate of interest will increase the investment and through multiplier it will increase in the income. Another way the government is able to increase the level of income is by its expenditure government under this situation can inject money in the economy by taking up certain public and social projects like making of A dams it will augment the income level of the economy.

When the economy is facing inflationary gap and it is a two sector economy then the only measure which can be adopted is to increase the rate of interest that will lower the rate of interest level of investment and hence income.