SESSION 4: DEFLATIONARY AND INFLATIONARY GAPS
You are cordially invited to the third meeting of the second unit. In our previous meeting, we examined the components of planned aggregate expenditure and its impact on national income in equilibrium.
SESSION: 3: DETERMINATION OF EQUILIBRIUM NATIONAL INCOME
At low or high levels of economic activity, it is simple to demonstrate that the economy could be stable or in equilibrium.
Low economic activity indicates that the nation’s resources are unemployed, whereas high economic activity indicates that the economy is functioning at or near full employment.
Thus, the concept of deflationary and inflationary deficits is born. In this session, we will endeavor to explain deflationary and inflationary gaps, their impact on economic activity, and how these gaps could be closed from two different vantage points.
Objectives By the close of this session, we should be able to
- understand full employment
- define inflationary gaps
- explain deflationary gaps
Now read on…
4.1 Full Employment Equilibrium
The equilibrium level of national income (Ye) is not necessarily the level of income (i.e., economic activity) at which all resources (factors of production) are completely utilized.
In other words, Ye is not necessarily associated with a position of full employment (Yfe). A full employment equilibrium is a special case in which aggregate planned expenditure coincides precisely with the economy’s productive capacity (i.e., potential GDP), with neither demand deficiency nor excess demand occurring.
This definition of full employment equilibrium provides a reference point for describing other economic conditions, such as those involving deflationary and inflationary gaps.
4.2 A Deflationary Gap
A deflationary gap (also referred to as a capacity gap or output gap) represents a situation of inadequate demand in the economy and is the amount by which aggregate planned expenditure (AE) must be increased in order to raise the equilibrium level of national income (Ye) to its full employment potential (Yfe).
Deflationary and inflationary gaps
A Deflationary Gap
The equilibrium level of national income in diagram (a) is Ye, according to the figure above. Total planned expenditures are less than the country’s potential output (Yfe) if all resources were utilized to their maximum capacity.
Due to a lack of demand, the economy is suffering from unemployment or underutilization of people and other resources. While all prices are fixed in the short term, the persistence of a deflationary gap is likely to eventually contribute to a decline in prices, or deflation.
Note that the term deflationary gap, as defined here, represents a situation of demand shortfall that may contribute to falling prices, whereas deflation refers to an actual fall in prices.
4.3 An Inflationary Gap
An inflationary gap represents a situation of excess demand in the economy and reflects the amount by which aggregate planned expenditure (AE) must be reduced in order to attain full employment equilibrium output with stable prices.
The equilibrium national income (Ye) in diagram (b) is to the right of the level of full employment (Yfe) in diagram (a). In other words, the required level of aggregate planned expenditures exceeds the output value achievable at full employment with stable prices.
Since the output cannot be increased in the short term (since the economy is operating at full capacity), the persistence of an inflationary gap will eventually result in an increase in prices (i.e. inflation) unless it is reduced.
Inflation caused by a surplus of demand in the economy is referred to as demand-pull inflation. Hope you recall?
4.4 Overheating
Given that the domestic economy will be unable to satisfy the demand for products and services in the near future, excess demand is also likely to result in increased import penetration.
It is said that an economy is overheating when inflationary pressures and import penetration coexist.
4.5 Closing the Deflationary and Inflationary Gaps
Neither deflationary nor inflationary gaps are typically regarded as desirable, so the next obvious issue is:
How can these voids be closed so that full employment and stable prices can be achieved?
Answering this query raises arguably the most contentious issue in macroeconomics today.
What is a permissible level of state intervention in economic management? What do you consider to be the best?
Let’s examine two schools of thought and their respective arguments regarding bridging the gaps.
4.4.1 Free Market Economists
On the one hand, free-market economists (who are frequently monetarists) argue that private enterprise and competitive markets will eventually restore a national income equilibrium with full employment and low or negative inflation. The free market is self-regulatory; therefore, state intervention is, at best, superfluous and, at worst, detrimental to the operation of market forces.
4.4.2 Keynesians (along with Marxist Economists)
They contest the notion that the market economy can be relied upon to adjust to full employment with stable prices.
They believe that the process will either not occur at all or, if it does, will take too long and have undesirable economic, social, and political consequences.
In order to rectify deflationary pressures or stifle inflation, the government can therefore exert influence over aggregate expenditures. Using fiscal policy, they shifted the responsibility for managing aggregate expenditure to the government. Specifically, they propose fiscal policy measures, which may include either or both of the following:
- Changes in personal and corporate taxation influence consumer spending and business investment expenditure plans and therefore aggregate expenditure.
- Direct changes in government spending plans, again influence aggregate expenditure.
In addition to using fiscal policy to influence consumer spending, Keynesians propose the following;
- Introduction of investment incentives
- Changed interest rates
- Export inducements, and
- Import controls of various kinds to limit spending on imports.
Such attempts by governments to moderate economic activity in a Keynesian manner are typically referred to as’stop-go’ or ‘fine-tuning’ economic policies. I hope you enjoyed the presentation.
This session examined the distinction between deflationary and inflationary gaps, their effects on the economy, and how the gaps can be closed using either the approach of free market economists or of Keynesians.
Self-Assessment Questions
Exercise 2.4
- Using examples, explain inflationary and deflationary gaps.
- What is meant by fine-tuning?
- How will you close an inflationary or deflationary gap as a free market economist?
- Keynesians propose the use of fiscal policies to correct inflationary and deflationary gaps. Explain how this can be done in an economy like Ghana’s.
- What other measures have been suggested by Keynesians to avert inflationary and deflationary gaps?
