Inflationary Gap occurs when AD > AS corresponding to full employment level. This inflationary gap, i.e., excess of aggregate demand causes inflation in the economy and price levels tend to rise.
In the above figure,
ADFE = AD at full employment level
ADAE = AD above full employment level
The point E is the equilibrium point where AD = AS. But the excess demand (current) of ADAE, aggregate demand FP is more than the aggregate supply in the economy. This difference of actual aggregate demand and supply i.e., EF is the Inflationary Gap.
Inflationary Gap = Excess Demand
= ADAE – ADFE = EF
Deflationary Gap refers to Aggregate Demand falling short of Aggregate Supply at the full employment level of income. It is called deflationary because it brings in deflationary tendencies.
ADFE = Aggregate Demand at full employment level:
ADIU= AD at involuntary unemployment level. The point E is equilibrium point, where AD = AS. But at the current, deficient demand due to involuntary unemployment of ADIU, the aggregate demand FP is less than actual supply in the economy. Hence, EF is Deflationary Gap.
Measure to Correct the Gap:
Statutory Liquidity Ratio: SLR refers to a fixed percentage of the total assets of a bank in the form of cash or other liquid assets that is required to be maintained by the bank. During the situation of Inflationary Gap, SLR is increased. This reduces the credit creation capacity of Commercial Banks and reduces the flow of money in the economy. As a result of that, the aggregate demand comes down and ultimately the economy attains equilibrium.
During the situation of Deflationary Gap, SLR is reduced. This increases the credit creation capacity of the Commercial Banks and increases the flow of money in the economy. As a result of that the aggregate demand increases and ultimately the economy attains equilibrium.
