Explain a concept of deflationary gap with the help of a diagram.
or
Draw a diagram showing deflationary gap.

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.

Meaning of deficient demand. When in an economy aggregate demand falls short of aggregate supply at full employment, the demand is said to be a deficient demand and the difference (gap) is called deflationary gap. Deficient demand gives rise to deflationary gap which causes income, output and employment to full and thus pushes the economy to an under-employment equilibrium. As a result some of the resources including labour remain partly unutilised showing under-employment. In other words, it means that the demand is not sufficient or adequate to eliminate involuntary unemployment. It indicates that there are people who are willing to take up jobs at the prevailing wage rate but the economy cannot provide jobs to them because current AD falls short of aggregate demand required to reach the level of full employment. Thus deficient demand is a situation of under-employment equilibrium.
Impact: Deficient demand leads to fall in prices which, in turn, leads to fall in output and employment. Again a persistent fall in deficient demand leads to state of depression in the economy.

Measures to rectify the situation of deficient demand. In view of adverse effects as stated above, there is great need to close the deflationary gap. Aggregate demand has to be increased by an amount equal to deflationary gap. The most important measures to remedy such a situation are fiscal policy, monetary policy and foreign trade policy. Even then some important measures are briefly discussed below:

1.    Fiscal Policy (Increase investment and reduce taxes). Fiscal policy comprises expenditure policy and taxation policy of the government. Government has legal powers to impose taxes and to spend. Main tools of fiscal policy are (i) expenditure policy, (ii) revenue policy, (iii) deficit financing, and (iv) public borrowing.

(i)    Expenditure Policy (Increase expenditure). The objective of expenditure policy should be to pump more money in the system that gives a fillip to the demand. During period of deficiency in demand, the government should make large investments in public works like construction of roads, bridges, buildings, railway lines, canals and provide free education and medical facilities although it may enlarge budget deficit. The aim is to give more money in the hands of people so that they should also spend more. Keynes, in fact, advocated deficit budget to step up aggregate demand.

(ii)    Revenue Policy (Reduce tax rate). Taxes on personal incomes and taxes on expenditures on buildings, etc. should be reduced. If possible, tax on lower income groups be abolished. This will increase their disposable income for spending. In addition, subsidies, old age pension, unemployment allowance and grants, interest free loans should be given.

(iii) Deficit financing (printing of currency-notes) should be encouraged as additional currency causes additional purchasing power.

(iv) Government borrowing from public should be discouraged, so as to increase aggregate demand.

2.    Monetary Policy (Reduce bank rate and Cash reserve ratio). Monetary policy is the policy of the Central Bank of a country to control credit and money supply. Mind, credit generally refers to the finance provided to others at a certain rate of interest. The aim of monetary policy in times of depression is to cause an increase in the investment expenditure by firms. Thus credit is made cheap and easily available in the following ways:

(a) Quantitative Measures
(i) Bank rate (Reduce it). Bank rate is the rate at which Central Bank lends to the commercial banks. The banks, in turn, increase or decrease lending rates of interest accordingly. To check depression, the Central Bank reduces bank rate thereby enabling the commercial banks to take more loans from it and, in turn, give more loans to producers at a lower rate of interest. At present (February 2012) bank rate (also called Repo Rate) is 8.5%.

(ii)    Open Market Operation (Buy securities). These refer to buying and selling of government securities which influence money supply in the economy. During depression, Central Bank buys Government bonds and securities from commercial banks by paying in cash to increase their cash stock and lending capacity.

(iii)    Cash Reserve Ratio (Reduce CRR). Central Bank lowers rate of cash reserve ratio thereby increasing bank's capacity to give credit. Similarly, Central Bank lowers Statutory Liquidity Ratio (SLR) to increase availability of credit.

Among these three instruments of monetary policy, the instrument of bank rate is more effective to lift the economy out of recession.

The above-mentioned three measures are quantitative credit control measures since they affect the quantity of cash and credit available in the economy.

(b) Qualitative Measures

There are qualitative measures also which regulate credit for specific purposes. They channelise credit into priority sectors and impede its use in undesirable sectors of economy as explained below.

(iv) Margin Requirement (Reduce it). To check depression, Central Bank reduces margin requirement which encourages borrowing because it induces businessmen to get more credit against their security.

(v) Moral Suasion. In a situation of deficient demand, Central Bank persuades, requests, appeals or advises its member banks to be liberal in lending and expand credit facilities.

(vi) Rationing of credit and sometimes direct action are also resorted to promote social justice while checking state of depression.

3. Foreign trade policy (Enlarge export surplus). In national accounting, it was made clear that exports are a part of domestic investment. So additional exports, like domestic investment, increase income and spending. Exports constitute foreign demand for domestic products. More exports have the effect of increasing aggregate demand. Therefore, when an economy suffers from deficient demand, it can reduce its deflationary gap by creating and increasing export surplus (excess of exports over imports). All efforts should be made to encourage export and discourage imports for generating more employment and income. For this the country may set apart for export a part of its domestic product which is in demand abroad.

Having discussed the two theories in the foregoing pages, we can now make the following comparison: