The Concept of Inflationary and Deflationary Gaps (Explained With Diagram)
The Concept of Inflationary and Deflationary Gaps!
It is useful and important to understand the concept of inflationary gap because with it we are able to know the main cause of the rise in general level of prices.
The equilibrium of an economy is established at the level of full-employment when aggregate demand or total expenditure is equal to the level of income corresponding to full-employment.
This happens when the amount of investment is equal to the saving gap corresponding to full-employment level of income.
Consider Fig. 5.10 where OYF is national income corresponding to the level of full-employment. Equilibrium at national income OYF would be established only when aggregate demand or total expenditure (C + / + G) is equal to YFE (YFE is equal to OYF).
Real national income cannot increase beyond OYF because when all means of production including labour are fully employed, there is no possibility of further rise in production or real national income.
Thus when aggregate demand is greater than the aggregate demand YFE which is required to establish the equilibrium at OYF level of national income, the equilibrium would not be established at OYF.It would be seen from Fig. 5.
10 that aggregate demand YFT is greater than aggregate demand YFE which is required to maintain the equilibrium at OYF.
Thus with the level of aggregate demand (C + I + G’), which is obtained by adding expenditure ET to the aggregate demand curve C + I + G, equilibrium would not be established at OYF which corresponds to full-employment level of income. The actual aggregate demand being greater than YFE by the amount ET the level of nation income would be greater than OYF.
Since OYF is full-employment level of national income, actual production cannot increase beyond that but there would be rise in prices which would raise the money value of OYF production.
The amount by which the actual aggregate demand exceeds the level of national income corresponding to full employment is known as inflationary gap because this excess of aggregate demand causes inflation or rise in prices in the country.
In Fig. 5.10 this excess of aggregate demand or inflationary gap is equal to ET. It would be seen from Fig. 5.10 that the aggregate demand curve C + I + G’ intersects 45° line (OZ line) at H so that equilibrium level of national income would be OY2.
It should be carefully understood that there is no difference between OYF and OY2 in terms of real income or actual production; only as a result of rise in price level, national income has increased from OYF to OY2 in money terms. Inflationary gap represents excess demand in relation to aggregate production or supply of output which brings about demand-pull inflation.
Keynes in his revolutionary book “General Theory of Employment, Interest and Money” did not discuss the concept of inflationary gap because he was then preoccupied with the analysis of the state of depression and deflation.
During the Second World War when the problem of inflation cropped up, then Keynes applied his macroeconomic analysis to explain inflation as well and in this connection he put forward the concept of inflationary gap.
In the theory of income and employment, the concept of deflationary gap occupies an important place, since in a capitalist economy unemployment and depression occur due to this gap.
According to Keynesian theory of income and employment, equilibrium at the level of full- employment is established when aggregate demand consisting of consumption demand plus investment demand plus government demand (C + I + G) is equal to the national income at the level of full-employment.
This happens when investment and government demand is equal to the saving gap at full-employment level of national income. If aggregate demand is less than the full-employment level of national income, i.e.
, when investment and government demand is less than the saving gap at full-employment level of income, the deficiency of aggregate demand occurs due to which national income and employment will fall below the full-employment level causing unemployment and depression in the economy.
The concept of deflationary gap is illustrated in Fig. 5.11 in which along the X-axis national income is measured and along the K-axis level of aggregate demand is measured. Suppose national income at the level of full-employment is equal to OYF.
Now the equilibrium level of income and employment would be established at OYF when aggregate demand (consumption demand plus investment demand) is equal to YFE (which is equal to national income OYF). But in the real world if aggregate demand is less than the full-employment level of income OYF or it is less than YFE, then the problem of deficiency of aggregate demand will arise.
Therefore, EK in Fig. 5.11 represents deflationary gap. Hence, deflationary gap represents the difference between the actual aggregated demand and the aggregate demand which is required to establish the equilibrium at full-employment level of income.
It should be carefully understood that due to the deflationary gap EK, the level of national income and employment will decline. The decline in national income and employment will not only be equal to the deflationary gap EK but it will be much greater than this. The decline in national income is determined by the value of the multiplier.
In Fig. 5.11 when aggregate demand curve is C + I+ G’ deflationary gap is equal to EK. The aggregate demand curve C + I + G’ (dotted) which cuts the 45° line at point Q asp result of which equilibrium is established at OYF level of national income. It will be seen from Fig. 5.11 that OY1, is less than full-employment level of income OYF.
Deflationary gap represents the situation of deficient demand in the economy.This deficiency in aggregate demand causes fall in national output and level of employment. As a result, involuntary unemployment in the economy emerges.
The depression of 1929-33 in capitalist countries was caused by the emergence of deflationary gap or by demand deficiency in these economies.
Inflationary and Deflationary Gap (With Diagram)
Let us learn about Inflationary and Deflationary 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.
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.
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.
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.
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.