Deflationary gap

Definition deflationary gap – This is the difference between the full employment level of output and actual output. For example, in a recession, the deflationary gap may be quite substantial, indicative of the high rates of unemployment and underused resources. A deflationary gap is also known as a negative output gap.

Causes of deflationary gap

  • Fall in aggregate demand (AD) due to
    • Fall in exports (global recession)
    • Fall in investment (due to 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 slower rate than productive capacity)

Diagram showing deflationary gap

negative-output-gapThis shows that after a fall in AD, real output (Y2) is significantly less than the level of ‘full employment’ Yf.

We can also show a deflationary gap with a production possibility frontier.

With a deflationary gap, it implies that output is significantly below potential.

pareto-efficiency

The deflationary gap would be at point D.

Deflationary gap and long-run trend rate of growth

The deflationary gap is also influenced by the rate of economic growth compared to the long-run trend rate of growth. If growth is below trend we will get a deflationary gap.

real-gdp-trend-actual

The deflationary gap in the UK economy post 2008/09 recession.

Impact of deflationary gap

If an economy experiences a deflationary gap, then it will have the following impact on the wider macroeconomy.

  • Rising Unemployment. We will get demand-deficient unemployment and possibly higher structural unemployment
  • Low/negative rates of economic growth.
    • Negative impact on 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.

Difference between deflationary gap and deflation

  • Deflation means a fall in the price level – (a negative rate of inflation)
  • A deflationary gap means that the economy is below full capacity and there is low growth. It doesn’t necessarily mean deflation because even in a recession with falling output, we may still get a very low rate of inflation.

Related concepts

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