Inflationary & Deflationary Gaps (Cambridge (CIE) A Level Economics): Revision Note

Bridge to the multiplier and components of AD

• The multiplier process established how an injection changes equilibrium national income

• The components of AD explained what drives the level of autonomous and induced spending

• This topic connects those two ideas to a crucial distinction: the equilibrium level of national income (where AE = Y) is not the same as the full employment level of national income (where all available resources are employed)

  • The gap between them is measured as either an inflationary gap or a deflationary gap, and it determines what kind of policy response is appropriate

Equilibrium income versus full employment income

• Equilibrium national income (Y) is the level of output at which aggregate expenditure equals national income

  • The economy settles here in the absence of policy changes

• Full employment level of national income (Y_FE) is the level of output at which all the economy's resources are fully employed

  • There is no cyclical unemployment and no spare capacity

• These two levels may coincide, but in general they do not

  • When equilibrium Y is below Y_FE there is a deflationary gap

  • When equilibrium AE exceeds what the economy can produce at Y_FE there is an inflationary gap

The deflationary (recessionary) gap

• A deflationary gap exists when the equilibrium level of national income lies below the full employment level

  • At Y_FE, aggregate expenditure is insufficient to buy all the output the economy is capable of producing

Diagram analysis

• Equilibrium national income is at Y₁, where the AE curve crosses the 45° line

  • The full employment level of income is at Y_FE, to the right of Y₁

• At Y_FE, aggregate expenditure is below the 45° line

  • Planned spending is less than the output the economy can produce at full employment

• The deflationary gap is the vertical distance between the 45° line and the AE curve at Y_FE

  • It measures the amount by which AE would need to rise to bring equilibrium Y up to Y_FE

• Because equilibrium Y is below Y_FE, the economy has spare capacity and cyclical unemployment

• Closing the deflationary gap requires an upward shift in AE, typically through expansionary fiscal policy, expansionary monetary policy or a rise in exports

Deflationary gap on the AD/AS diagram: the negative output gap

• The same situation can be shown on an AD/AS diagram

• Where the deflationary gap measures the shortfall in planned expenditure, the negative output gap measures the resulting shortfall in real output

Diagram analysis

• The potential (full employment) output of the economy is at Y_FE, shown by the vertical LRAS curve

• Short-run equilibrium is at AP₁Y₁, where AD intersects SRAS to the left of Y_FE

• The negative output gap is the horizontal distance Y₁ − Y_FE, showing actual output is below potential output

• The economy has spare capacity in the short run - firms can expand output without significant pressure on prices

• This situation typically arises when AD has fallen, for example due to a collapse in consumer confidence, a tightening of credit or a fall in exports

• Rising unemployment and slow economic growth are indicators that a negative output gap is widening

The inflationary gap

• An inflationary gap exists when aggregate expenditure exceeds the output the economy can produce at full employment

• Equilibrium Y cannot physically rise above Y_FE, so the excess demand instead generates demand-pull inflation

Diagram analysis

• The full employment level of income is at Y_FE

• At Y_FE, the AE curve lies above the 45° line

  • Planned expenditure exceeds the output the economy is capable of producing

• The inflationary gap is the vertical distance between the AE curve and the 45° line at Y_FE

  • It measures the amount by which AE would need to fall to eliminate excess demand

• Because the economy cannot produce more than Y_FE, the excess demand pushes up the average price level rather than raising real output

  • This is demand-pull inflation

• Closing the inflationary gap requires a downward shift in AE, typically through contractionary fiscal policy, contractionary monetary policy or measures that reduce net exports

Inflationary gap on the AD/AS diagram: the positive output gap

• On an AD/AS diagram, the inflationary gap corresponds to a short-run equilibrium at which real output temporarily exceeds the economy's sustainable capacity

Diagram analysis

• The potential output of the economy is at Y_FE, shown by the vertical LRAS curve

• Short-run equilibrium is at AP₁Y₁, where AD intersects SRAS to the right of Y_FE

• The positive output gap is the horizontal distance Y_FE − Y₁, showing actual output is above sustainable potential output

• The economy is operating beyond its long-run capacity in the short run

  • Workers may be working overtime, machines operating at unsustainable intensity, and unemployment below the natural rate

  • This situation is not sustainable: rising costs and input shortages push SRAS leftward until the positive output gap is eliminated

• Rapidly rising prices are a key indicator that a positive output gap is developing

Keynesian and Classical views on how gaps close

• The two schools disagree on whether gaps close automatically without policy intervention

• The policy implication is significant

  • If the Keynesian view is correct, a deflationary gap requires active government intervention (expansionary fiscal and monetary policy) rather than being left to self-correct

Difficulties in measuring gaps

• Both types of gap are hard to measure accurately because:

  • The true full employment level of national income Y_FE cannot be directly observed

    • It must be estimated from indicators such as unemployment rates, capacity utilisation and inflation

  • Estimates of Y_FE are revised regularly as new data emerge

  • Rapidly rising prices can indicate a positive output gap is developing, but may also reflect cost-push pressures unrelated to demand

  • Rising unemployment and a slowdown in growth can indicate a widening negative output gap, but may also reflect structural changes in the economy

• This measurement uncertainty means that policymakers face a real risk of responding to the wrong diagnosis

  • Tightening policy when the economy actually has spare capacity, or loosening policy when the economy is already overheating