Deflationary gap indicates _____ (excess/deficient) demand in an economy. (Fill in the blank with correct answ

Question 27 of 104

Q. Deflationary gap indicates _________ (excess/deficient) demand in an economy. (Fill in the blank with correct answer)

Manipur CohsemCBSE Class XII Board 2020Subjective· 1mImportance★★★★★

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Concept understanding — Aggregate Demand Equilibrium

Aggregate Demand Equilibrium: The Economy's Balancing Act

Think of a seesaw. On one side sits everything people, firms, and the government want to buy. On the other side sits everything firms produce. When the seesaw is perfectly level — when total spending exactly matches total output — the economy is in equilibrium. That's the core idea.

But why should you care? Because when the seesaw tilts, real things happen. If spending exceeds output, prices rise (inflation). If output exceeds spending, factories shut down and people lose jobs. Equilibrium is the sweet spot where neither happens.

The Precise Meaning

In macroeconomics, Aggregate Demand (AD) is the total planned spending on final goods and services in an economy during a given period. Aggregate Supply (AS) is the total output firms plan to produce.

Equilibrium occurs where:

AD = AS

At this point, what buyers intend to spend exactly equals what sellers intend to produce. No unwanted inventories pile up, and no shortages force prices up. The economy is "at rest."

Y = C + I + G + (X - M)

This is the AD identity from your NCERT textbook. It tells you that total spending in the economy comes from four sources: households, firms, government, and foreigners (net of what we buy from them).

How Equilibrium Actually Works

Imagine a simple economy with only households and firms. Households earn income $Y$ from firms. They spend part of it on consumption $C$ and save the rest $S$ . Firms produce output and also invest $I$ (buying machines, building factories).

Equilibrium condition becomes:

Y = C + I

But households don't spend all their income. They save. So $C = Y - S$ . Substituting:

Y = (Y - S) + I

Which simplifies to:

S = I

Important

In equilibrium, planned savings must equal planned investment. This is the Keynesian cross condition. If people save more than firms invest, total spending falls short of output — inventories pile up, firms cut production, and income falls until savings and investment match again.

The 45° Line Diagram (Describe It)

Draw a graph with Aggregate Demand (AD) on the vertical axis and National Income (Y) on the horizontal axis.

Draw a 45° line from the origin. Every point on this line represents $AD = Y$ — the equilibrium condition.
Draw the AD curve (which is $C + I + G + (X-M)$ ). It slopes upward because as income rises, consumption rises.
Where the AD curve crosses the 45° line — that's the equilibrium point. …

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A deflationary gap arises when the aggregate demand in an economy is less than the aggregate supply at the full employment level, indicating deficient demand.

To understand the deflationary gap, we first need to consider the concept of full employment equilibrium. Full employment refers to a situation where all available resources in an economy, including labor, are optimally utilized. At this level, the economy produces its potential output, and there is no involuntary unemployment. For an economy to sustain this full employment level of output, there must be an adequate level of aggregate demand (AD) to purchase all the goods and services produced.

A deflationary gap occurs when the actual aggregate demand in the economy falls short of the aggregate demand required to achieve full employment. In simpler terms, it means that the total spending by households, firms, and the government is not enough to buy all the goods and services that the economy could produce if all its resources were fully employed.

Note

The aggregate demand required for full employment is often referred to as the "full employment aggregate demand." The deflationary gap is the difference between this required AD and the actual AD.

When there is a deflationary gap, it implies that there is insufficient demand in the economy. This lack of demand leads to several consequences:

Underutilization of Resources: Firms find that they cannot sell all the goods they produce at full capacity, leading them to reduce production. …

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Q.Deflationary gap indicates _________ (excess/deficient) demand in an economy. (Fill in the blank with correct answer)

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