{"id":25426,"date":"2022-06-13T09:39:26","date_gmt":"2022-06-13T09:39:26","guid":{"rendered":"https:\/\/www.5paisa.com\/finschool\/?post_type=finance-dictionary&p=25426"},"modified":"2024-10-23T16:00:50","modified_gmt":"2024-10-23T10:30:50","slug":"deflationary-gap-2","status":"publish","type":"finance-dictionary","link":"https:\/\/www.5paisa.com\/finschool\/finance-dictionary\/deflationary-gap-2\/","title":{"rendered":"Deflationary Gap"},"content":{"rendered":"\t\t
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A deflationary gap occurs when an economy’s actual output is below its potential output, indicating underutilized resources such as labor and capital. This gap arises due to insufficient aggregate demand, leading to high unemployment and downward pressure on prices, often resulting in deflation.<\/p>

It reflects a situation where the economy is producing less than it could at full employment, causing slower growth. Governments and central banks often respond by implementing expansionary fiscal and monetary policies, such as lowering interest rates or increasing spending, to stimulate demand and close the gap, restoring economic balance.<\/p><\/div><\/div><\/div><\/div>

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Causes of Deflationary Gap<\/b><\/strong><\/h2>

Fall in the money supply<\/b><\/strong><\/p>

A\u00a0central bank\u00a0may use a tighter monetary policy by increasing\u00a0interest rates. Thus, people, instead of \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0spending their money immediately, prefer to save more of it. In addition, increasing interest rates lead to higher borrowing costs, which also discourages spending in the economy.<\/p>

\u00a0<\/b><\/strong>Decline in confidence<\/b><\/strong><\/p>

Negative events in the economy, such as recession, may also cause a fall in aggregate demand. For example, during a recession, people can become more pessimistic about the future of the economy. Subsequently, they prefer to increase their savings and reduce current spending. An increase in aggregate supply is another trigger for deflation. Subsequently, producers will face fiercer competition and be forced to lower prices. The growth in aggregate supply can be caused by the following factors:<\/p>

\u00a0<\/b><\/strong>Lower production costs<\/b><\/strong><\/p>

A decline in price for key production inputs (e.g., oil) will lower production costs. Producers will be able to increase production output, which will lead to an oversupply in the economy. If demand remains unchanged, producers will need to lower their prices on goods to keep people buying them.<\/p>

\u00a0<\/b><\/strong>Technological advances<\/b><\/strong><\/p>

Advances in technology or rapid application of new technologies in production can cause an increase in aggregate supply. Technological advances will allow producers to lower costs. Thus, the prices of products will likely go down.<\/p>

Differences between the inflationary gap and deflationary gap.<\/b><\/strong><\/p><\/td><\/tr>

Basis<\/b><\/strong><\/p><\/td>

Inflationary Gap<\/b><\/strong><\/p><\/td>

Deflationary Gap<\/b><\/strong><\/p><\/td><\/tr>

Meaning<\/strong><\/p><\/td>

The excess of aggregate demand above the level that is required to\u00a0maintain full\u00a0employment level\u00a0of equilibrium is\u00a0termed as inflationary gap.<\/p><\/td>

The shortfall of\u00a0aggregate demand\u00a0below the level that\u00a0is required\u00a0to maintain full\u00a0employment level\u00a0of equilibrium is\u00a0termed as\u00a0a deflationary gap.<\/p><\/td><\/tr>

Effect<\/strong><\/p><\/td>

Inflationary gap\u00a0causes inflation\u00a0and increases\u00a0wages and price\u00a0level in the\u00a0economy.<\/p><\/td>

Deflationary gap causes deflation\u00a0and decreases\u00a0wages and price\u00a0level in the\u00a0economy.<\/p><\/td><\/tr>

Causes<\/strong><\/p><\/td>

Some of the causes are as follows:<\/p>

Rise in one or more components of AD<\/p>

Fall in tax rate<\/p>

Rise in money supply<\/p><\/td>

Some of the causes are as follows:<\/p>

Fall in one or more components of AD<\/p>

Rise in tax rate<\/p>

Fall in money supply<\/p><\/td><\/tr>

Meaning<\/strong><\/p><\/td>

The excess of aggregate demand above the level that is required to\u00a0maintain full\u00a0employment level\u00a0of equilibrium is\u00a0termed as inflationary gap.<\/p><\/td>

The shortfall of\u00a0aggregate demand\u00a0below the level that\u00a0is required\u00a0to maintain full\u00a0employment level\u00a0of equilibrium is\u00a0termed as\u00a0a deflationary gap.<\/p><\/td><\/tr>

Effect<\/strong><\/p><\/td>

Inflationary gap\u00a0causes inflation\u00a0and increases\u00a0wages and price\u00a0level in the\u00a0economy.<\/p><\/td>

Deflationary gap causes deflation\u00a0and decreases\u00a0wages and price\u00a0level in the\u00a0economy.<\/p><\/td><\/tr><\/tbody><\/table>

Impact of Deflationary Gap<\/b><\/strong><\/h2>

If an economy experiences a deflationary gap, then it will have the following impact on the wider macro\u00a0economy.\u00a0<\/p>