Deflationary Gap-Deflationary gap is the deficiency of AD required to maintain full employment equilibrium Deflationary gap occurs when AD < AS (corresponding to full employment level). Open market operation is the policy that focuses on increasing and decreasing the stock of liquidity (or cash balances) with the people as well as with the Commercial Banks, through sale and purchase of securities by the Central Bank. During the situations of Deflationary Gap, when cash balances need to be increased (to stimulate the level of Aggregate Demand), the Central Bank starts buying securities. Purchase of securities injects purchasing power into the money market. Cash balances of the Commercial banks start picking up. This enhances their capacity to create credit. Consequent upon the greater flow of credit flow' in the economy, Aggregate Demand is increased Deflationary gap is corrected.
