A deflationary gap occurs when the actual real GDP is below its potential output. In this situation, some economic resources are underutilized, which in turn, creating a downward pressure on price level. This term is synonymous with the recessionary gap or the Okun gap.
Does the deflationary gap has the same meaning as deflation?
The two terms are different concepts. The deflationary gap refers to conditions where the productive capacity of the economy is underutilized, while deflation is a condition when the general price level declines (negative inflation).
Even though output is below its potential level, inflation may still be positive but at a lower rate. Therefore, deflationary gaps do not always create deflation in the economy, although the price level is more likely to be depressed downward because businesses face excess capacity.
How do deflationary gaps occur?
Economists call the deviation of real GDP from its potential as the output gap. The output gap can be positive or negative. The positive output gap occurs when aggregate demand and short-run aggregate supply intersects (short-run equilibrium) above its potential output. This situation refers to the inflationary gap (positive output gap).
However, when short-run equilibrium is below its potential output, it is a deflationary gap (negative output gap).
Causes of deflationary gap
A deflationary gap could occur when aggregate demand declines. For example, the global recession reduces foreign demand for domestic products. Exports decline, so do with aggregate demand.
High-interest rate environment also contributes to lower aggregate demand. In this case, new loans become more costly. Households reduce their spending on durable goods, and companies postpone their investment spending.
Other factors that reduce aggregate demand are higher taxes, more pessimistic consumers and businesses, and lower equity and housing prices.
A decrease in aggregate demand results in lower real GDP and lower prices levels. The economy operates below its potential output.
Implications on the economy
When the economy experiences a deflationary gap, economic growth and inflation rate are lower (or even negative). When a decrease in aggregate demand bring the economy into a recession, real GDP and the price level fall (deflation).
Companies face excess capacity. Prices and wages put on the downward pressure. Their profit margins shrink and force them to reduce labor, causing a higher unemployment rate.
Households become more pessimistic on their future job and income prospects. As a result, they spend less on goods and services.
For the government, a decline in economic activity causes tax revenues to fall.
In financial markets, investors will usually reduce investment in cyclical companies and commodity-based companies. They began to reallocate investment more on defensive companies as they have a more stable performance during an economic slowdown.