Deflationary Gap

A deflationary gap is the amount by which aggregate demand falls short of the level required to achieve full employment, so that the economy operates below its potential. The concept originates in Keynesian economics and is used to analyse the causes of unemployment and the scope for policy.

Definition

The deflationary gap is measured as the difference between the level of aggregate demand at full employment and the actual level of demand. It represents the additional demand that would be required to bring the economy to full employment, given the existing price level and the existing productive capacity.

The concept is related to the output gap, which measures the difference between actual and potential output. The deflationary gap focuses on the demand side, while the output gap measures the outcome. A deflationary gap manifests as an output gap when it is not offset by policy or by the adjustment of prices and wages.

Causes

A deflationary gap arises when aggregate demand declines relative to the capacity of the economy. It can be caused by a fall in consumption, a fall in investment, a fall in government spending, or a fall in net exports.

The causes can be domestic or external. A financial crisis can reduce consumption and investment through the destruction of wealth and the tightening of credit. A recession in trading partners can reduce exports. A fiscal consolidation can reduce demand directly.

The gap can also arise from an increase in the supply capacity of the economy that is not matched by an increase in demand. An increase in productivity, or an increase in the labour force, can raise potential output while demand grows more slowly, creating a gap.

Consequences

The main consequence of a deflationary gap is unemployment. When demand falls short of the level required for full employment, firms reduce output and employment, so that the unemployment rate rises. The unemployment is involuntary, in the sense that workers would be willing to work at the prevailing wage but cannot find jobs.

A deflationary gap also puts downward pressure on prices and wages. When demand is weak, firms may cut prices to maintain sales, and workers may accept lower wages to preserve employment. The resulting deflation can worsen the gap by raising the real burden of debt and by encouraging households to postpone spending.

The gap can have persistent effects. Prolonged unemployment erodes skills and attachment to the labour market, so that the potential output of the economy itself may decline. This hysteresis effect means that the costs of a deflationary gap can be long-lasting.

Policy

The definition of a deflationary gap points to the policy response. Fiscal policy can raise demand by increasing spending or cutting taxes. Monetary policy can lower interest rates and expand liquidity. The aim is to close the gap and to restore full employment, without generating inflation.

The effectiveness of policy depends on the size of the gap, on the responsiveness of demand to the instruments, and on the constraints on policy. When the gap is large, and when interest rates are at their lower bound, fiscal policy may be more effective than monetary policy. Coordination between the two can enhance the response.

Keynes and the Concept

The concept of the deflationary gap was developed in the context of Keynesian economics, which emphasised the role of aggregate demand in determining output and employment. Keynes argued that an economy could settle at an equilibrium with unemployment, and that the gap between actual and full-employment demand explained the persistence of that unemployment.

The analysis was developed further by Keynes's followers, who formalised the concept of the gap and related it to the analysis of the multiplier and of the budget. The gap measures the shortfall in demand, and the multiplier determines the increase in output that results from an increase in demand.

The concept was influential in the post-war period, when it informed the design of fiscal policy and the use of demand management. It was challenged in the 1970s, when the coexistence of unemployment and inflation called into question the simple relationship between demand and employment, but it remains a central concept in macroeconomic analysis.

The Output Gap and the Deflationary Gap

The deflationary gap is related to, but distinct from, the output gap. The deflationary gap measures the shortfall in demand relative to the level required for full employment, while the output gap measures the shortfall in output relative to potential output.

The two concepts diverge when prices and wages adjust. If a deflationary gap persists, prices and wages may fall, which can reduce the gap in real terms and thereby reduce the output gap. The relationship between the two therefore depends on the flexibility of prices and wages and on the response of expectations.

The measurement of both concepts is difficult in practice. Potential output is not observed, and it must be estimated using statistical methods or based on production functions. The estimates are subject to revision, and the uncertainty about potential output complicates the assessment of the gap and the design of policy.

Remedies and their Limits

The remedies for a deflationary gap are the instruments of demand management. Fiscal policy can raise demand through increased spending or reduced taxes, and monetary policy can lower interest rates and expand liquidity. The aim is to close the gap and to restore full employment.

The remedies are subject to limits. When the deflationary gap is large and persistent, the required increase in demand may be too large for the available fiscal space, and the zero lower bound may limit the scope for monetary easing. In such circumstances, unconventional measures and the coordination of policy may be required.

A further limit is that the response of demand to policy is uncertain. The size of the multiplier, the responsiveness of investment to interest rates, and the effect of policy on expectations all affect the outcome, and they are not known with precision. Policy must therefore be designed to be robust to uncertainty, and it must be adjusted as information accumulates.

Summary

The deflationary gap is a central concept in the analysis of demand-deficient unemployment. It relates to the output gap and to the design of demand management, and its measurement and its remedies are subject to uncertainty and to limits.

See also

• Demand Management
• Keynesian Economics
• Output Gap