(i) Inflationary Gap: Inflationary gap arises when consumption and investment spending together are greater than the full employment GNP level. This means that people are demanding more goods and services than can be produced. In other words the implication of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased for goods and services on the part of people will be to raise the price level. Or we may say that there will be inflationary gap if scheduled investment tends to be greater than full employment saving. In a situation like this ore goods will be demanded than the economic system can produce. The result will be that the prices will begin to rise and an inflationary situation will emerge. Thus if full employment saving falls short of scheduled investment at full employment there will be an inflationary gap.
The inflationary gap can be explained with the help of above diagram. C.I.G stand for the consumption, investment and Government expenditure respectively, C+I+G line shows the total expenditure on demand in economy. At the level Yx is the total real output, as shown by intersection point D with the 45° line. YFx represents a full employment limit on real output YFx. Real income of the economy obviously cannot reach Yx- at YFx total demand (C+I+G) exceeds total output, leaving a gap AB which is the inflationary gap in the Keynesian sense.
(ii) Deflationary Gap: As we have drawn above the diagram in order to explain the inflationary gap, in the same way we can explain the deflationary gap with the help of diagram given as under.
Deflationary gap would come into existence if total aggregate demand is insufficient to create full employment Yx is the total output at full employment. Let us assume that the total demand is (C+I+G) which cuts the 45° line at B, with real output Yx. AB then is the deflationary gap.
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