Deflationary Gap

Definition

A deflationary gap refers to a situation where the aggregate demand in an economy is insufficient to purchase all the goods and services produced at the full employment level of output, leading to a decrease in the overall price level. This concept is closely tied to Keynes' Law and Say's Law in the Aggregate Demand/Aggregate Supply (AD/AS) model.

5 Must Know Facts For Your Next Test

1. A deflationary gap occurs when the aggregate demand in an economy is less than the aggregate supply at the full employment level of output.
2. This leads to a decrease in the overall price level, as firms are unable to sell all of their production at the current prices.
3. Keynes' Law states that aggregate demand determines the level of output, while Say's Law suggests that supply creates its own demand.
4. The deflationary gap represents a situation where Keynes' Law takes precedence, as the lack of aggregate demand leads to a decrease in output and employment.
5. Governments and central banks may use expansionary fiscal and monetary policies to address a deflationary gap and restore full employment.

Review Questions

• Explain how the concept of a deflationary gap relates to Keynes' Law in the AD/AS model.
  • According to Keynes' Law, the level of output in an economy is determined by the aggregate demand. In a deflationary gap, the aggregate demand is insufficient to purchase all the goods and services produced at the full employment level of output. This means that the actual level of output will be lower than the full employment level, as firms will be unable to sell their entire production at the current prices. The deflationary gap, therefore, represents a situation where Keynes' Law takes precedence, as the lack of aggregate demand leads to a decrease in output and employment.
• Contrast the deflationary gap with the concept of Say's Law in the AD/AS model.
  • Say's Law suggests that supply creates its own demand, implying that the full employment level of output will always be achieved. However, the deflationary gap represents a situation where this is not the case. In the deflationary gap, the aggregate demand is insufficient to purchase all the goods and services produced at the full employment level of output, leading to a decrease in the overall price level. This contradicts the premise of Say's Law, which states that supply will generate its own demand. The deflationary gap, therefore, highlights the importance of aggregate demand in determining the level of output, as opposed to the supply-side focus of Say's Law.
• Discuss the potential policy responses that governments and central banks may use to address a deflationary gap in the AD/AS model.
  • To address a deflationary gap, governments and central banks may implement expansionary fiscal and monetary policies. Expansionary fiscal policy, such as increased government spending or tax cuts, can help stimulate aggregate demand and close the deflationary gap. Expansionary monetary policy, such as lowering interest rates or increasing the money supply, can also boost aggregate demand and encourage investment and consumption. These policy interventions aim to shift the aggregate demand curve to the right, increasing the level of output and employment and restoring the economy to the full employment level. By addressing the lack of aggregate demand, governments and central banks can mitigate the deflationary pressures and promote economic stability.

Related terms

Aggregate Demand (AD):

The total demand for all goods and services in an economy at a given price level and time period.

Aggregate Supply (AS):

The total quantity of goods and services that firms are willing to sell at different price levels in a given time period.

Full Employment Level of Output: The level of output where the economy is operating at its maximum sustainable capacity with all available resources fully utilized.