Hi there I have a question about this concept. The book says that the 'full-employment level of GDP (Yf) is the level of GDP at which there is no deficiency of aggregate demand (E)'. Then it says that 'the recessionary (deflationary) gap shows by how much aggregate demand is deficient at the full-employment level of income'. These two statements appear to be inconsistent. If one says that there is no deficiency of aggregate demand at a certain level of GDP, how can it be the case in the sentence below that there can be? What am I missing?
Hi Yes, this does sound confusing. I think we need to say something about equilibrium income here. The equilibrium level of Y (or GDP) occurs where Agg D = Agg S (or Y or GDP), ie where the Agg D line crosses the 45 degree line. This could occur at any level of Y, so if Agg D is very low, equilibrium Y will be low and it could be below the full employment level of Y. If Agg D is too low to ensure full employment, we can see how deficient demand is (ie we can see the size of the deflationary gap) by looking at the gap between what Agg D would be IF actual Y = Yf and what it would need to be to make Yf = equilibrium. For example, if Agg D = 100+0.8Y, then equilibrium Y = 500. If Yf = 600, then the economy is producing too little to provide full employment. There is insufficient demand, ie there is demand-deficient unemployment. To reach Yf, demand must be increased. By how much? By the extent of the deflationary gap. Using the Agg D function, we can see that IF actual GDP = 600, Agg D would only be 580, (ie it is deficient by 20 at Yf) so injections would need to increase by 20 (to make Agg D = 120+0.8Y) to make equilibrium = 600 = Yf. So when Yf exists, there is no deficiency of demand. Hope this helps.
