Question

Explain the concept of `Deflationary Gap' with the help of a diagram.

Hint:

Deflationary Gap is cured by expansionary fiscal policy (increase government spending, reduce taxes) to boost Aggregate Demand up to the full employment level.

Answer 1

Step 1: Understanding the Concept:
A deflationary gap arises when Aggregate Demand (\(AD\)) is less than the level required to maintain full employment output. It is a sign of deficient demand.
Step 2: Detailed Explanation:
1. Definition: It is the amount by which actual aggregate demand falls short of the aggregate demand required to establish full employment equilibrium.
2. Impact: This shortfall leads to a decline in prices (deflationary pressure), increase in unsold stocks, and involuntary unemployment.
Step 3: Diagrammatic Representation:
- On a graph where the X-axis is Income/Output and the Y-axis is \(AD\):
- Draw the \(45^{\circ}\) line representing Aggregate Supply (\(AS\)).
- Draw the \(AD_{FE}\) curve intersecting the \(AS\) at the full employment point \(E\).
- Draw the actual \(AD\) curve (\(AD_{actual}\)) below \(AD_{FE}\).
- The vertical distance between these two curves at the full employment level of output represents the Deflationary Gap.
Step 4: Final Answer:
The deflationary gap measures the deficiency of demand in an economy, indicating that the economy is operating below its full capacity.