Deflationary gap. When aggregate demand is less than the level of output at full employment, then the deficiency or gap is called deflationary gap. It is the difference between the actual level of aggregate demand and the level of aggregate demand required to establish the full employment equilibrium. It is a measure of the amount of deficiency in aggregate demand. Briefly, deflationary gap is synonym of deficient demand. The gap is called deflationary gap because it leads to deflation. For instance, suppose an economy by fully utilising all its available resources can produce 10,000 qtls. of rice. If the actual aggregate demand for rice is, say 8,000 qtls. This demand will be termed as deficient demand and the gap of 2,000 qtls as deflationary gap. Clearly, here equilibrium between AD and AS is at 8,000 qtls. Keynes called it an under-employment equilibrium. Deflationary gap or deficient demand causes low income, low output and low employment in the economy.
Deflationary gap has been illustrated in Fig.(a). Here, E lying on 45° line is the full employment equilibrium point. This is an ideal situation because aggregate demand represented by EM is equal to 'aggregate supply at full employment' represented by OM. Suppose actual aggregate demand is for a level of output BM. For the economy to maintain level of output at full employment, aggregate demand should be EM (OM) but actual aggregate demand is BM. The gap between the two (i.e. EM and BM) is EB which is measure of deflationary gap or deficient demand. In short, deflationary gap is the difference between the actual level of aggregate demand and the level of aggregate demand required to establish full employment equilibrium.

 

Impact of deficient demand. (i) Deficient demand reduces economy s output, income and employment. How? Due to deficient demand, inventories (stock) of unsold goods will accumulate, and therefore, the producers will cut down production by reducing employment. Thus both output and employment will continue to fall until a new equilibrium is reached at E_r In fact, basic problem with deficient demand is lack of full utilisation of available resources in the form of idle labour force, unutilised industrial capacity and uncultivated lands, i.e., involuntary unemployment.
(ii) It causes situation of depression. If deficiency in demand (or deflationary gap) is not bridged, it can lead to fall in output, employment and prices, and therefore, to depression. Depression refers to a phase of economic activity where falling production and incomes lead to fall in demand, and therefore, fall in prices. Once started, the process of depression is self-generating. This is what happened during Great Depression of 1929-33. It is under such like situation that Keynes advocated government intervention in the form of fiscal policy measures to correct situation of deficient demand.
Causes of deficient demand. These are: (i) Fall in government expenditure, (ii) Fall in level of Autonomous investment, (iii) Decrease in Marginal Propensity to consume, and (iv) Fall in supply of money and credit.