DETERMINATION OF NATIONAL INCOME
4. INFLATIONARY AND DEFLATIONARY GAPS
J. M. Keynes in his famous book ‘General Theory’ put forward an analysis of unemployment and inflation. The Keynesian theory assumes that a maximum level of national output can be obtained at any particular time in the economy. According to him, the maximum level of national income is generally referred to as full employment level of national income. If the equilibrium level of national income coincides with the full employment, there will be no deficiency of aggregate demand and hence no dis-equilibrium unemployment (However seasonal, frictional unemployment can exist at this level).
Now if the equilibrium level of income as determined by the AD (aggregate demand) and AS (aggregate supply) is not equal to the level of full employment, then two situations can arise. Either this equilibrium level will be below the full employment level or above the lull employment level. In case, the equilibrium income is below the potential income, it indicates the presence of recessionary gap. If it is above the full employment income, it shows the presence of inflationary gal:). Both the situations of deflationary and inflationary gaps are situations of disequilibrium in the economy. These gaps are now explained with the help of graphs.
(A) Deflationary gap.
Deflationary gap is also called re-cessionary gap. When there is an insufficient demand for goods and services in the economy, the equilibrium will occur at the lower –level of full employment income and to the left of full employment line. In other words, re-cessionary gap occurs when the aggregate demand consisting of consumption demand, investment demand and government expenditure is not sufficient to create conditions of full employment. The deflationary gap thus is the difference of amount by which aggregate expenditure falls short of the level needed to generate equilibrium national income at full employment without inflation. The deflationary gap is illustrated in figure below:
In the figure 31.5, national income is measured along OX axis and aggregate demand (consisting of consumption demand plus investment demand plus government expenditure) is measured along ‘OY axis. Let us assume that the national income at the level. of full employment is equal to OYF. This . equilibrium level of national income is
established at OYF only when aggregate demand C + G’ is equal to aggregate supply
of output YFE. In case aggregate demand falls to YfH, it will be EH short of aggregate demand YfE which is required to establish equilibrium at full employment level of national income. There EH represents the deflationary gap. Hence, deflationary gap represents the difference between the actual aggregate demand and the aggregate supply at full employment level of output or income.
Impacton output, employment and prices:
The fall in aggregate demand C + 1 + Gi as seen by the dotted line in figure 31.5 shows the deflationary gap EH. The decline in national income and employment will be much greater than the deflationary gap EH. The decline in national income depends upon the value of the multiplier. The aggregate demand curve C + 1 + G’ as shown by the dotted line intersects the 450 line at point Q. As a result, equilibrium is established at OY° level of .national income. The level of national income OY° is less Than the full employment level of Oyf. Hence, the deficiency in aggregate demand causes fall in output, decline in employment and fall in the general price level.
Fiscal measures to correct deficient demand:
When aggregate expenditure for gbods and services is less than the aggregate supply of output which can be produced by fully employing the given resources of the economy, then the deficiency of demand arises. This deficiency of demand. can be corrected by two important fiscal measures (i) Increase in government expenditure and (ii) reduction in taxes. J. M. Keynes recommended the increase in government expenditure on public works programmes such as construction of roads, railways, canals etc. to tackle the problem of deficient demand. The increase in public expenditure has a
multiplier effect on raising income and employment. –
Reduction in taxes is also an important fiscal measure to raise aggregate demand. 77,e cutting down of taxes increases peoples disposable income and raises profitability of
the business sector. This leads to increase both in consumption demand and investment demand. The rise in aggregate demand helps in pulling the economy out of recession.
(B) Inflationary Gap
An inflationary gap is just the opposite of deflationary gap. It is said to exist when the aggregate demand for goods and services exceeds the aggregate supply of output at the full employment level of income. When inflationary gap emerges in the economy, it leads to the general rise in prices which is generally described as demand pull inflation. In the situation of demand pull inflation, there is no increase in real output and employment in the economy. The rise in prices of goods occur due to excess demand. The increase in the price of output occurs in money terms only and not in real terms. An inflationary gap is explained with the help of figure below:
In this figure 31.6, equilibrium of the economy is established at the level of full employment when aggregate demand is equal to the level of national income. Suppose the level of national income and the level of full employment is equal to OYf. This equilibrium is established only when aggregate demand C + 1 + G is equal to YfE (YfE is equal to OYf). It is assumed that at this equilibrium of national income, all the resources of production are full employed and there is no possibility of further rise in production of national income.
The rise in aggregate demand C + 1 + GI as shown by the dotted line cuts the 45′ line, at point H and as a result, the new equilibrium is established at 0Y2 level of national income which is greater than OYf. In terms of actual production, there is no difference between OYf and 0Y2. It is only as a result of increase in price that national income has gone up. The excess demand equal to ET represents inflationary gap. Since OYt is full employment level of national income, real production cannot increase beyond that output. Therefore, excess demand will lead to rise in prices which would raise only the •money value of OYf, amount of production and national income remaining the same. The amount by which actual aggregate demand exceeds the level of national income is known as inflationary gap.
Measures to reduce inflationary gap: The excess expenditure can be reduced by reducing non-development government expenditures such as expenditures on public administration, defence and subsidies on non-merit goods. Monetary measures such as
increase in cash reserve ratio, mopping up of liquid resources with the banks through’ open market operations etc., by the central bank so as to reduce the availability of credit.
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