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Deflationary gap is opposite of inflationary gap. It arises when the volume of goods and services is larger than the aggregate demand. Deflationary gap may be defined as the amount by which aggregate expenditure falls short of the aggregate income at full employment level. In other words, the excess of aggregate supply over the aggregate demand if full employment is achieved is known as deflationary gap. This can be illustrated with the help of a diagram.

In Figure 11.4, the aggregate expenditure is shown by (C+I+G) This curve intersects the 450  line at point ‘E’, which gives the equilibrium income OYF . This is also full employment  income at current prices. Now, suppose governmental expenditure falls, as a result of which new aggregate expenditure becomes (C+I+G’). This (C+I+G’) curve is parallel to the original (C+I+G) curve by the amount of EA.  At the full employment level of income, the aggregate supply (money income) is OYF or EYF . This is greater than aggregate demand (expenditure) of AYF . The deflationary gap is EA, that is, the amount by which aggregate expenditure falls short of full employment income. Whenever deflationary gap occurs, the economy cannot be in equilibrium at full employment. When income is reduced to the equilibrium level of OY, the gap will disappear.

To wipe out the deflationary gap, the government can raise the expenditure by investing in public works. Alternatively, the community may raise its consumption or investment expenditure.

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