When in an economy aggregate demand falls short of aggregate supply at full employment level, i.e. the production is more than the demand, the demand is said to be deficient demand and the gap is called deflationary gap.
Causes of the deflationary gap are:
Fall in aggregate demand (AD) due to:
- Fall in exports (global recession)
- Fall in investment (due to a banking collapse and credit crunch)
- Fall in consumer spending (e.g. higher interest rates, falling wages.).
- Economic growth well below the average trend rate of growth (AD increasing at a slower rate than productive capacity).
Impact of deflationary gap:
- Rising Unemployment: We will get demand-deficient unemployment and possibly higher structural unemployment.
- Low/negative rates of economic growth.
- Negative impact on the government’s budget: With lower economic growth, the government will receive lower tax revenue and lower government spending.
- Low rates of inflation/disinflation: Possibly deflation. With a deflationary gap, firms have excess capacity, this tends to put downward pressure on prices and wages.