Deflation gap

From CEOpedia | Management online

Deflation gap - it is a situation in which the sum of expenses (this is about spending on goods and services produced in the country) is lower than the national income (inflows lower than outflows) at the national income ensuring full employment. If the national income at the equilibrium point (Ye) is below the full employment level (Yf), there will be an under-utilization of the production capacity in the economy, and thus unemployment will emerge due to a shortage of demand. This phenomenon is called deflationary gap.

The size of the deflation gap is shown by the section a - b, i.e. the distance between line 45 and line E at the national income providing full employment (Yf). It is also the size, c - d, i.e. the size by which the outflows exceed the inlets. If the national income is to be increased from Ye to Yf, the inflows must be increased and / or outflows reduced to eliminate the deflation gap. Note that the size of the deflation gap is less than the difference between Ye and Yf. This is another example of a multiplier. If the inflows are increased, oa - b (and thus ocd), the national income will increase by Yf - Ye. The multiplier therefore has the form:

(Yf - Ye) / a - b

What is deflation?

Deflation is the general decline in prices for goods and services occurring when the inflation rate falls below 0%. Deflation happens naturally when the money supply of an economy is fixed. In times of deflation, the purchasing power of currency and wages are higher than they otherwise would have been. This is distinct from but similar to price deflation, which is a general decrease in the price level.

Examples of Deflation gap

  • Deflationary gaps can occur when a decrease in aggregate demand (AD) occurs, leading to a decrease in national income. This could be due to a decrease in government spending, a decrease in business investment, or a decrease in consumer spending. A deflationary gap can be seen in the 2008-09 Recession, when a decrease in AD led to a decrease in national income, causing unemployment and a decrease in GDP.
  • Deflationary gaps can also occur when the rate of inflation is too low. If the rate of inflation is below the rate of growth of the economy, then aggregate demand will fall, leading to a decrease in national income and, ultimately, an underutilization of the economy's production capacity. This occurred in Japan during the 1990s, when the rate of inflation was below the rate of economic growth, leading to a deflationary gap and a period of prolonged economic stagnation.
  • Last, deflationary gaps can also occur when there is an increase in savings. If consumers increase their savings rate, then aggregate demand will decrease, leading to a decrease in national income and, ultimately, an underutilization of the economy's production capacity. This occurred in the United States during the Great Recession of 2008-09, when consumers increased their savings rate, leading to a decrease in aggregate demand and a deflationary gap.

Advantages of Deflation gap

Deflationary gaps provide a number of potential advantages for an economy. These include:

  • Increased economic efficiency as resources are shifted to more productive uses. This can lead to improved economic growth and increased business investment.
  • Reduced inflationary pressures as demand decreases, leading to lower prices.
  • Increased consumer spending as people are more likely to buy goods and services when prices are lower.
  • Improved employment opportunities as businesses are more likely to hire workers when demand is high.
  • Increased productivity as businesses become more efficient due to increased competition.
  • Reduced government borrowing costs as the government can borrow funds at lower interest rates, providing more funds for government programs.

Limitations of Deflation gap

The deflation gap presents some limitations that must be taken into account when analyzing the economy:

  • It fails to take into account the impact of the government's fiscal policy on the economy. The government can alter the level of spending and taxation to stimulate the economy and reduce the gap.
  • It fails to account for changes in prices and wages. When the prices of goods and services fall, the gap can decrease. Similarly, when wages increase, the gap can also decrease.
  • It doesn't account for changes in the money supply. When the money supply increases, the gap can be reduced as more money is available for spending.
  • It doesn't take into account the impact of imports and exports. An increase in imports can reduce the gap, while an increase in exports can increase the gap.
  • It doesn't take into account changes in the demand for goods and services. When demand rises, the gap can be reduced, but when demand decreases, the gap can be widened.

Other approaches related to Deflation gap

One approach to dealing with deflationary gaps is by increasing government spending. This can be done through government initiatives such as public works projects, infrastructure investments, and tax incentives. Other approaches include monetary policy measures such as increasing the money supply, lowering interest rates, and encouraging investment. Fiscal policy measures such as increasing taxes, reducing government spending, and reducing public debt can also help to close deflationary gaps. Finally, structural reforms such as deregulation and labor market reforms can improve economic efficiency and help close deflationary gaps. In summary, deflationary gaps can be dealt with by using a combination of monetary, fiscal, and structural policy measures.


Deflation gap — recommended articles
Disinflation — Galloping inflation — Crowding out effect — Demand shock — Inflationary gap — Supply shock — Ratchet effect — Underconsumption — Structural inflation

References

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