What is deflationary gap explain it with the help of diagram and suggest some fiscal measures to correct it

Due to the deficiency in the aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as deflationary gap. This gap measures the amount of deficiency in the level of aggregate demand. Graphically, it is represented by the vertical distance between the aggregate demand at the full employment level of output(AD_F ) and the actual level of aggregate demand (AD_E ).In the figure below,EYdenotes the aggregate demand at full employment level of output andCYdenotes the actual aggregate demand. The vertical distance between these two represents deflationary gap. That is,

EY CY=EC (Deflationary Gap)

Let us understand the situation of deficit demand and concept of deflationary gap with the help of the following figure.

In the figure,AD ₁and AS represents the aggregate demand curve and aggregate supply curve. The economy is at full employment equilibrium at point E, whereAD ₁intersectsAScurve. At this equilibrium point,OYrepresents the full employment level of output andEYis the aggregate demand at the full employment level of output.

Let us suppose that the actual aggregate demand for output is onlyCY, which is lower thanEY. This implies that actual aggregate output demanded by the economyCYfalls short of the potential (full employment) aggregate outputEY. Thus, the economy is facing a deficiency in demand. This situation is termed as deficit demand. As a result of the deficit demand, deflationary gap arises. The deflationary gap is measured by the vertical distance between the potential (or full employment level) aggregate demand and the actual aggregate demand for output. In other words, the distance betweenEYandCY, i.e.ECrepresents the deflationary gap.

In this case, the producers will experience piling up of unsold stock due to deficiency in demand. As a result, the producers will attempt to clear the stock of unsold goods by reducing the production of output, thereby reducing employment level. The producers will continue to reduce the production till the new equilibrium is reached at point F, where the new aggregate demand curveAD ₂intersects the AS curve. At this new equilibrium, the economy is producingOY ´level of output and the aggregate output demanded by the economyisFY´. The new equilibrium level of output, income and employment is lesser than that of at the full employment level of equilibrium. Thus, it can be observed that due to the deflationary gap created by the deficit demand, the economy has attained a less than full employment level of equilibrium.