Explain the concept of `Deflationary Gap' with the help of a diagram.
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Solution and Explanation
In Keynesian economics, full employment is not automatically guaranteed. When Aggregate Demand is insufficient to generate full employment output, an output gap arises.
Step 2: Detailed Explanation:
A Deflationary Gap (also called a Recessionary Gap) refers to the shortfall in Aggregate Demand (AD) relative to the level of Aggregate Demand required to maintain full employment equilibrium.
In the diagram below, the $45°$ line represents the full employment level. $AD_{FE}$ is the required AD for full employment, and $AD_A$ is the actual (lower) AD. The vertical distance between $AD_{FE}$ and $AD_A$ at the full employment level of income is the Deflationary Gap. This results in less output, income, and employment than the potential, causing deflation and recession.
Step 3: Final Answer:
Deflationary Gap = Shortfall in Aggregate Demand at the full employment level, leading to a fall in output, income, and employment.
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