Inflationary Gap occurs when AD > AS corresponding to full employment level. This inflationary gap, i.e., excess of aggregate demand causes inflation in the economy and price levels tend to rise.
In the above figure,
ADFE = AD at full employment level
ADAE = AD above full employment level
The point E is the equilibrium point where AD = AS. But the excess demand (current) of ADAE, aggregate demand FP is more than the aggregate supply in the economy. This difference of actual aggregate demand and supply i.e., EF is the Inflationary Gap.
Inflationary Gap = Excess Demand
= ADAE – ADFE = EF
Deflationary Gap refers to Aggregate Demand falling short of Aggregate Supply at the full employment level of income. It is called deflationary because it brings in deflationary tendencies.
ADFE = Aggregate Demand at full employment level:
ADIU= AD at involuntary unemployment level. The point E is equilibrium point, where AD = AS. But at the current, deficient demand due to involuntary unemployment of ADIU, the aggregate demand FP is less than actual supply in the economy. Hence, EF is Deflationary Gap.
