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where there is unemployment of resources
 
there is said to be a 
deflationary gap
. Prices 
are fairly constant and real output changes as aggregate demand varies. A deflationary gap can be 
described as the extent to which the aggregate demand function will have to shift upward to produce the 
full employment level of national income. 
3.6 Stagflation 
In the 1970s there was a problem with 
stagflation
: a combination of unacceptably high unemployment, 
unacceptably high inflation and low/negative economic growth. One of the causes was diagnosed as the 
major rises in the price of crude oil that took place. The cost of energy rose and this had the effect of 
rendering some production unprofitable.
 
National income fell, and both prices and unemployment rose. Any long-term major increase in costs (a 
price shock
) is likely to have this effect. 
3.7 Summary 
An equilibrium national income will be reached where aggregate demand equals aggregate supply. There 
are two possible equilibria. 
(a) 
One is at a level of demand which exceeds the productive capabilities of the economy at full 
employment, and there is insufficient output capacity in the economy to meet demand at current 
prices. There is then an 
inflationary gap
. 
(b) 
The other is at a level of employment which is below the full employment level of national 
income. The difference between actual national income and full employment national income is 
called a
 
deflationary gap
. To create full employment, the total national income (expenditure) 
must be increased by the amount of the deflationary gap. 
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CHAPTER 3
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THE MACROECONOMIC ENVIRONMENT