Deflationary Gap refers to Aggregate Demand falling short of Aggregate Supply at the full employment level of income. It is called deflationary because it deflationary tendencies.
Margin requirements refers to the discount on the security mortgaged by the borrower. It is determined by the Central Bank. In case of Deflationary Gap, the Central Bank reduces the discount so that the capacity to borrow is increased. This raises AD.
Detailed Answer:
When there is involuntary unemployment in the economy, there is a short fall in AD from the level that is required to maintain a full employment equilibrium. The short fall is termed as deflationary gap.
In this figure, ADFE = AD at full employment level
ADIU = AD at involunatry unemployment level
The point E is the equilibrium point, where AD = AS. But at the current, deficient demand situation (due to involunatry unemployment) of ADIU the Aggregate Demand FP is less than the actual supply in the economy. Hence, EF is the deflationary gap.
Deflationary Gap = Deficient Demand
= ADFE – ADIU
=EF
Role of Margin Requirement to Deflationary Gap
Reduce Margin requirement refers to the difference between the amount of loan granted and the current value of security offered for loans.
In case of deflationary gap, the margin requirements are lowered to increase the flow of credit by encouraging people to borrow. As a result the AD increases and ultimately the economy attains equilibrium.
