Deficient demand! How does it produce depression in the economy?

Deficient demand refers to the situation when aggregate demand for goods and services falls short of aggregate supply of output which is produced by fully employing the given resources of the economy. This deficient demand leads to the decrease in output, employment and prices in the economy.

The equilibrium at full employment level of national income is achieved when aggregate demand equals aggregate supply of output given the resources of the economy such as capital and labour. But the aggregate demand for goods and services of the economy may be less than aggregate supply at full employment level of resources. This creates the problem of deficient demand in the economy.

The deficiency in aggregate demand leads to wide spread unemployment of labour on the one hand and under utilization of the capital and other resources of the economy on the other. This state of unemployment and under utilization of resources due to lack of aggregate demand is called depression. In such a situation the economy has the adequate capital stock to produce goods and to employ labour force but it cannot do because there is not enough demand for the goods to be produced by them.

According to Keynesian theory of income, employment and output, equilibrium at the level of full employment is established when aggregate demand consisting of consumption demand plus investment demand plus Govt, demand (C+l+G) is equal to the aggregate output at the level of full employment.

This happens when investment and Govt, demand is equal to the saving gap at full-employment level of aggregate supply of output i.e. when Govt, demand and investment demand is less than saving gap at full employment level of income, the deficiency of aggregate demand occurs due to which national output and employment will fall below the full employment level causing unemployment and depression in the economy.

The concept of deflationary gap is just opposite of the inflationary gap as illustrated by John Maynard Keynes. The deflationary gap for the economy as a whole may be defined as a shortage of anticipated expenditure compared with the available output of goods and services at base price.

The deflationary gap is a situation where the anticipated expenditure falls short of available output at base prices. The deflationary gap is illustrated in the above diagram. The anticipated expenditure or the aggregate demand function is represented by C+l+G. the 45° line OZ indicates that aggregate demand is equal to aggregate supply.

That means income is equal to expenditure. The aggregate demand function C+l+G intersects the line OZ at the point P, This gives us the equilibrium income indicated by OM, Thus OM represents full employment income at the base price.

The aggregate demand (C+l+G) is P, Mr This P, M, is equivalent to the total output of goods and services amounting to OM, Since the total money income is equal to the total available output, there is no question of any shortage of demand arising in the economy, hence there is no possibility of the emergence of a deflationary gap in the economy. Supposing the aggregate demand expenditure (C+l+G) is reduced by certain amount of government expenditure and the new expenditure function in the economy is (C+l+G¹).

Since OM, is the national income of the economy at the full employment level it does not decrease with the reduced Govt, expenditure (G,) amounting to P₂N₂. This P₂N₂ represent deflationary gap in the economy. It lowers down the price level. The price level can remain constant only if the output of goods and services decreases from OM, to OM₂. In other words the output of goods and services must be reduced by M₂M; the deflationary gap of P₂N₂ can be wiped-out only if the output of goods and services decreases by M₂M.