Inflationary gap is the amount by which the actual aggregate demand exceeds aggregate supply at the level of full employment. For instance, in Fig.(a), BE is show'n as inflationary gap. It is a measure of amount of the excess of aggregate demand. It causes a rise in price level called inflation.
Deflationary gap is the amount by which the actual aggregate demand falls short of aggregate supply at the level of full employment (i.e., falls short of full employment output). For example, in Fig.(b) EB is shown as deflationary gap. It is a measure of amount of deficiency of aggregate demand which is required to establish full employment equilibrium. It causes a decline in output, income and employment along with fall in prices.
Between inflationary gap (causing inflation) and deflationary gap (causing deflation or depression), the latter is worse because of its serious economic consequences. Moreover, deflation (fall in price level) is difficult to control than inflation.
Fig.(a)
Fig.(b)
Deflationary gap and equilibrium level of income
Equilibrium level of income indicates mere equality between aggregate demand and aggregate supply irrespective of whether it is a full employment equilibrium or under-employment equilibrium. If it is a full employment equilibrium where all resources are employed to their full limit, deflationary gap cannot exist at equilibrium level of income. On the other hand, if it is an under-employment equilibrium where all resources are not fully employed, i.e., some resources are under-employed, then deflation gap can exist at equilibrium level of income.
Conclusion. We may conclude our discussion in this way. Equilibrium level of national income is determined by the equality between aggregate demand and aggregate supply (or between savings and investment). An ideal situation for an economy is full employment equilibrium, i.e., when its aggregate demand and aggregate supply are in equilibrium at such a point where all the resources of the economy are employed fully. Every economy aspires for it. India should put in all efforts to achieve and stay at full employment equilibrium level of income.
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