Deflationary gap is the difference between the income representing the value of output (C+S) and the one representing the expenditure (C+I). In short, it means the differences between the investment, the output and the expenditure which occurs on the production. It represents the magnitude of the deficiency of investment when there remain ideal resources to be employed at the equilibrium level of income.
Deflationary gap is common feature is free economy where reliance is put on the automatic adjustment between saving and investment through market mechanism.
Once the deflationary gap is created, speculative activities further widen the gap and as such the condition goes from bad to worse. When the symptoms, that is, falling trend in prices and unemployment, appear in the economy, the entrepreneurs expecting further fall of price, plan their investment as a low level which reduces the employment opportunities and the gap is widened.
In short, the deflationary gap is created because of shrinking of investment to cover up the gap. Bridging the gap by increased investment is made possible by the fixed and monetary measures of the Government and the cooperation of the entrepreneurs. Cooperation of the entrepreneurs depends upon the profit incentives which the state has to create in the economy.
When the equilibrium level of output is less than the natural rate, as shown below, a Deflationary GAP exists. In the figure, the equilibrium level of output, Y, is less than the
natural level of output, Yn. A deflationary gap calls for an Expansionary Fiscal Policy, such as an
increase in government spending or reduction in taxes, or an Expansioanry Monetary Policy.
Such an expansionary policy shifts the AD curve to the right and increases the equilibrium level of
Deflationary gap is when there AD