inflationary and deflationary gap

• Inflationary gap


  Occurs when aggregate demand/expenditure exceeds the potential output in the economy, leading to excess demand and rising prices
• John Maynard Keynes: 'In the long run an economy will not achieve full employment without government intervention'
• Inflationary gap


  1. Aggregate expenditure exceeds potential output

  2. Not all demand can be met due to lack of resources

  3. Excess demand drives up price level
• Equilibrium output Y


  Above the potential level of output X
• Inflationary gap


  Represented by the distance Ab
• Solution to inflationary gap

  1. Government cuts its own expenditure

  2. Government raises taxes

  3. People spend less

  4. Aggregate demand falls
• Deflationary gap


  Occurs when the equilibrium level of income is below the full employment level
• Deflationary gap


  1. Lack of aggregate expenditure

  2. Equilibrium level of income Y is below full employment level X

  3. Deflationary gap is represented by VW
• Solution to deflationary gap

  1. Government increases spending by borrowing

  2. Government cuts taxation

  3. To get rid of deflationary gap
• Expansionary fiscal policy AIM: - Tax + spending + borrowing

  Expansionary monetary policy AIM: - OFC(interest rate) + money supply
• Expansionary, monetary and fiscal policy might not stimulate aggregate demand enough, or, it might overstimulate the economy, resulting in inflation. If the government underestimates the size of the multiplier, it might increase its spending by too much, which will result in demand pull inflation.
• expansionary fiscal policy and expansionary monetary policy to close a deflationary gap.
• Causes of Inflationary Gap

  High aggregate demand, exceeding supply, leading to increased production costs and price inflation
• deflationary fiscal and deflationary monetary policy to reduce an inflationary gap.