Inflationary gap occurs when aggregate demand (AD) exceeds aggregate supply (AS) at full employment level of output. In this case, money income rises to a higher equilibrium, but real income (being at full employment output level) remains unchanged.
As a result, there is an upward rise in prices because the consumers compete for limited supply of output and bid prices up.
In other words, inflationary gap reflects that at full employment level of output, real income cannot rise, but the prices rise to the extent that AD > AS at full employment.
Inflationary gap continues to prevail until either AD contracts to the level consistent with the full employment level or AS is expanded through economic growth.
In Figure 2A, Yf represents full employment output (i.e., the maximum output the economy can produce in a given short period).
The position of AS line (i.e. 45 ° line which represents Y = C + I + G) is such that at Yp AD is greater than AS by the amount AB. Thus, AB is the measure of inflationary gap, which is another name for excess demand measured at Yf.
Deflationary gap prevails when aggregate demand (AD) is less than aggregate supply (AS) at full employment level of output. In this case, income equilibrium occurs while some resources are unemployed.
In other, words, deflationary gap depicts unemployment situation attributable to the fact that at full employment level of output, AD <AS.
Thus, deflationary gap is measured as the difference between AD and AS at full employment, Deflationary gap, and the resultant conditions of unemployment and sluggish economic activity, will persist until a higher level of aggregate demand consistent with full employment is achieved.
In Figure 2B, Yf represents full employment output. The position of AS line (i.e., 450 line) is such that at Yp AD is less than AS by the amount BA. Thus, BA is the measure of deflationary gap, which is the same thing as deficient demand measured at Yf.
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