Inflationary And Deflationary Gap

Inflationary And Deflationary Gap:

In this article, we will inflationary gap, and deflationary gap which is related to inflation. Let us understand this one by one.

Inflationary Gap

An inflationary Gap is a condition when the demand for goods and services becomes higher than the production level. This happens due to higher levels of overall employment, trade activities, or government expenditure. This is a condition when the real GDP crosses the potential GDP.

The inflationary gap a condition that indicates that the economy is expanding due to the higher funds available in the market. Due to these higher funds, the demand for goods and services increases but at the same time, the supply is at the same level. Let us understand this with a graph.

In this graph, you can simply understand that the inflationary gap occurs when the aggregate demand increases but the supply remains stable.

The inflationary gap can be controlled through fiscal policy and monetary policy. Let us understand this one by one.

How Fiscal Policy Manage the Inflationary Gap

  • Fiscal policies are those policies that are used by the government.
  • To reduce the inflationary gap government takes these steps: reduce government spending, increases taxes, issue bond, and securities, etc.
  • By taking these steps the government reduces the circulation of money from the market. Due to this, the overall demand for goods and services declines and it helps to reduce the inflationary gap and restores the economic equilibrium.

How Monetary Policy Manage the Inflationary Gap

  • Monetary policies are those policies that are used by Central Bank.
  • To reduce the inflationary gap the Central Bank increases the interest rates. Higher interest rates make borrowing more expensive.
  • In other words, Central Bank implements a tight money policy or dear money policy to reduce the money circulation in the market. Less money in the market controls the higher demand and reduce the inflationary gap and restores the economic equilibrium.

Deflationary Gap

This is a condition when the aggregate demand is below the aggregate supply. In other words, when an economy produces more goods and services than actual demand (at full employment) then it triggers a deflationary gap. Let’s understand this situation by a graph.

In this graph, you can simply notice that aggregate demand (AD) at full employment is higher than the aggregate demand at involuntary unemployment. (Here the line ‘OY’ indicates the aggregate supply.)

The deflationary gap is triggered by factors like fall in exports, fall in investment, fall in consumer spending, and the slower growth rate of aggregate demand than productive capacity.

If an economy is facing a deflationary gap, then it will increase the demand deficient unemployment level. It also impacts the government budget and triggers negative or slow economic growth. The deflationary gap can also be controlled through fiscal policy and monetary policy. Let us understand this one by one.

How Fiscal Policy Manage the Deflationary Gap

  • Fiscal policies are those policies that are used by the government.
  • To reduce the deflationary gap government takes these steps: increase government spending, decrease taxes, etc.
  • The government also implements those policies which increase the public for spendings. It helps to reduce the deflationary gap and restores the economic equilibrium.

How Monetary Policy Manage the Deflationary Gap

  • Monetary policies are those policies that are used by Central Bank.
  • To reduce the deflationary gap the Central Bank decreases the interest rates. Cheaper interest rates make borrowing less expensive.
  • In other words, Central Bank implements a cheap money policy to reduce the money circulation in the market. More money in the market boosts the demand and reduce the deflationary gap and restores the economic equilibrium.

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