Let us learn about Inflationary and Deflationary Gap.
Inflationary Gap:
We have so far used the theory of aggregate demand to explain the emergence of DPI in an economy. This theory can now be used to analyse the concept of ‘inflationary gap’—a concept introduced first by Keynes. This concept may be used to measure the pressure of inflation.
If aggregate demand exceeds the aggregate value of output at the full employment level, there will exist an inflationary gap in the economy. Aggregate demand or aggregate expenditure is composed of consumption expenditure (C), investment expenditure (I), government expenditure (G) and the trade balance or the value of exports minus the value of imports (X – M).
Let us denote aggregate value of output at the full employment by Yf. This inflationary gap is given by C + I + G + (X – M) > Yf. The consequence of such gap is price rise. Prices continue to rise so long as this gap persists. Inflationary gap thus describes disequilibrium situation.
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Inflationary gap is thus the result of excess demand. It may be defined as the excess of planned levels of expenditure over the available output at base prices. An example will help us to clear the meaning of the concept of inflationary gap.
Suppose, the aggregate value of output at current price is Rs. 600 crore. The government now takes away output worth Rs. 100 crore for its own requirements, leaving thus Rs. 500 crore for civilian consumption. National income analysis says that the value of aggregate money income equals the net value of aggregate output.
Here also the total money income of the people (Rs. 500 crore) is equal to the net value of aggregate output (i.e., Rs. 600 crore – Rs. 100 crore = Rs. 500 crore). Thus, prices will remain stable since aggregate expenditure is equal to aggregate output. Let us further assume that the money income of the community is increased to Rs. 800 crore by creating additional purchasing power.
Let the government takes away Rs. 50 crore as taxes. A part of the increased income, say Rs. 100 crore, may now be saved. So the net disposal income available for spending becomes Rs. (800 – 50 – 100 =) 650 crore. Since the aggregate demand at old prices is Rs. 500 crore, an excess of Rs. 150 crore appears.
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This excess represents inflationary gap that pulls up prices. If there is no corresponding increase in aggregate output, prices will continue to rise until aggregate output becomes equal to aggregate expenditure.
Keynes’ demand inflation is often couched in terms of the concept of inflationary gap. We now graphically explain this gap with the help of the Keynesian cross that we use in connection with the determination of equilibrium national income. In Fig. 11.5, aggregate expenditure is measured on the vertical axis and national income or aggregate output is measured on the horizontal axis.
Let us assume that Yf is the full employment level of national income. If C + I + G + (X – M) is the aggregate demand (AD) curve that cuts the 45° line at point A then an equilibrium income is determinded at Yf. There will not be any price rise since aggregate demand equals aggregate supply. Now if the AD curve shifts up to AD’, equilibrium output will not increase since output cannot be increased beyond the full employment level.
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In other words, because of full employment, output cannot increase to Y*. Thus at Yf level of full employment output, there occurs an inflationary gap to the extent of AB. The vertical distance between the aggregate demand and the 45° line at the full employment level of national income is termed the inflationary gap. Or at full employment, there is an excess demand of AB that pulls up prices.
To describe inflationary gap in a simple way, we use Fig. 11.6. In this figure, we weigh aggregate demand (i.e., C + I + G + X-M) and aggregate supply. Since the former exceeds the latter, an inflationary gap emerges.
Inflationary gap can be eliminated/ minimized by using monetary policy and or fiscal policy instruments. Under the monetary policy, money supply is reduced and/or interest rates are increased. This gap, however, can be reduced either by reducing money income through reduction in government expenditure, or by increasing output of goods and services, or by increasing taxes.
Deflationary Gap:
If the equilibrium level of income is estimated to be below the full employment level of income then emerges deflationary gap. If in the economy there arises insufficient aggregate demand, equilibrium in the economy will occur to the left of the full employment income (Yf).
In other words, a deflationary gap shows the amount by which aggregate demand must be increased so that equilibrium level of income is increased to the full employment level. Fig 11.7 shows that equilibrium level of income is OY* while full employment output is Yf.
Thus, the economy faces unemployment situation. The distance between the 45° line and the AD line at the full employment output situation is referred as the deflationary gap. It is AB in Fig. 11.7. Since aggregate demand is less than the country’s potential output, the economy suffers from unemployment of labour and other resources.
The deficiency in aggregate demand thus causes price level to fall. This is what happened in the USA, UK, etc., in the 1930s. Keynes was arguing at that time that unemployment was the result of deficiency of aggregate demand. He suggested demand management policy (such as, increase in government spending, reduction in taxes, etc.,) to come out from the Great Depression of the 1930s.