IBonomicsOutput/Deflationary Gap – Below Full Employment EquilibriumSL
MacroeconomicsA diagram showing an output (deflationary) gap, where the economy is producing below its full employment level of output (Ye).
Curves and elements
- ad
- AD: Aggregate Demand, downward sloping due to the wealth effect, interest rate effect, and net export effect.
- sras
- SRAS: Short-Run Aggregate Supply, upward sloping due to increasing marginal costs.
- lras
- LRAS: Long-Run Aggregate Supply, vertical at full employment output (Ye).
- pl
- PL1: Price level at the current equilibrium where AD intersects SRAS.
- y1
- Y1: Current level of real output where the economy is operating below capacity.
- ye
- Ye: Full employment level of real GDP.
- gap
- Output/Deflationary Gap: The horizontal distance between Y1 and Ye, representing underutilized resources in the economy.
Key explanations
- 1
The AD curve intersects the SRAS curve at output level Y1, which is less than the full employment level of output Ye.
- 2
The vertical LRAS curve represents the full employment level of output, indicating the economy's maximum sustainable capacity.
- 3
At Y1, there is insufficient aggregate demand to fully utilize all available resources, leading to unemployment and downward pressure on prices.
- 4
The gap between Y1 and Ye is labeled as the output or deflationary gap, which implies underperformance in the economy.
- 5
This situation may require expansionary fiscal or monetary policies to shift AD rightward and close the gap.
Example exam question
Using an AD–AS diagram, explain what an output (deflationary) gap is and how it can be addressed by government policy.
Show example answer
An output or deflationary gap occurs when aggregate demand is too low to achieve full employment output (Ye), as shown by the equilibrium at Y1. This leads to unemployment and lower inflationary pressure. To address the gap, governments may use expansionary fiscal policies such as increasing spending or cutting taxes, or employ monetary policies like lowering interest rates to increase AD and close the gap.
