INTRODUCTION

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 fully employed. Let us denote aggregate value of output at the full
employment by Yf.
 If aggregate demand exceeds the aggregate value of output at the full employment
level, there will exist an EXCESS DEMAND or INFLATIONARY GAP in the
economy i.e ADf > ASf
 The consequence of such gap is price rise. (Let us suppose that an imaginary
economy by employing all its available resources can produce 10,000 qtls of rice. If
aggregate demand for rice is, say, 12,000 qtls., this demand will be called an excess
demand because aggregate supply at the level of full employment of resources is only
10,000 qtls. As a result, the excess of 2,000 qtls will be called an inflationary gap as it
will lead to price rise due to mismatch between demand and supply) Prices continue
to rise so long as this gap persists. Thus excess demand is also known as Inflationary
gap

 Suppose, the actual aggregate demand is for a level of output BYf which is greater
than full employment level of output AYf. The difference between the two is BA (BYf
– AYf)) which is a measure of inflationary gap or excess demand.
 EXCESS DEMAND= CURRENT DD( PI)- EFFECTIVE DEMAND(P0)
 In short, the inflationary gap is the amount by which the actual aggregate demand
exceeds the aggregate demand required to establish full Output and Income
employment equilibrium.
 The gap is called inflationary because it causes inflation (continuous rise in prices) in
the economy. In such a situation, an increase in demand means only an increase in
 money expenditure without any corresponding increases in output and employment
because all the resources have already been fully employed.
 The main reasons for excess demand are apparently the increase in any four
components of aggregate demand. For instance, there may be (i) increase in
household consumption demand due to rise in propensity to consume; (ii) increase in
private investment demand because of rise in credit facilities; (iii) increase in public
(government) expenditure; (iv) increase in export demand and (v) increase in money
supply (deficit financing) or increase in disposable income (due to fall in rate of
taxes).
 EFFECTS OF INFLATIONARY GAP:
(i) Output will not change as the economy is already at full employment level.
(ii) Employment opportunities will not change because economy is already at full
employment level.
(iii) Inflationary Gap leads to increase in prices.

Deflationary Gap: (UNDER EMPLOYMENT EQ)

 Let us denote aggregate value of output at the full employment by Yf.
 If in the economy there arises insufficient aggregate demand, i.e AD< ADf
i.e a situation in which Aggregate Demand is less than Aggregate Supply at full
employment level of income AD < ASf stocks will pile up, prices will fall leading to
deflation in the economy
 Thus gap between current demand and effective demand needed to secure full
employment is also known as deflationary gap or 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.

 For instance, in Fig. 8.17, EB is shown as deflationary gap. It is a measure of amount

of deficiency of aggregate demand.
Current demand=BM
Effective demand needed for full employment=EM
DEFICIENT DD= EFFECTIVE DD-CURRENT DD
Deficient demand=EM-BM=EB
 Equilibrium level of income indicates mere equality between aggregate demand and
aggregate supply regardless of whether the equilibrium is at full employment or
under-employment of resources. It occurs at E1 where AD actual cuts AS curve. As
equilibrium is achieved but all resources are not employed and there is involuntary
unemployment this equilibrium is also known as UNDEREMPLOYMENT EQ.In
other words, it means that 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.
EQUILIBRIUM
 CAUSES
The main reasons for DEFICIENT DEMAND are apparently the decrease in any
four components of aggregate demand. For instance, there may be (i) decrease in
household consumption demand due to fall in propensity to consume; (ii) decrease in
private investment demand because of fall in credit facilities; (iii) decrease in public
(government) expenditure; (iv) decrease in export demand and (v) decrease in money
supply or decrease in disposable income (due to rise in rate of taxes).
 IMPACT
Deflationary gap causes a decline in output, income and employment along with
persistent fall in prices.