Define Deflationary Gap. State, how the government can control the situation of deflationary gap, using the taxation policy.

Question

Accepted Answer

**Deflationary Gap** is the shortfall of actual aggregate demand below the aggregate demand required to establish full employment equilibrium. It arises when AD < AS at full employment level, leading to unemployment and under-utilization of resources.

**Government can control deflationary gap using taxation policy by:**
- **Reducing direct taxes** increases disposable income of households and profits of firms, boosting consumption and investment expenditure
- **Reducing indirect taxes** lowers prices of goods, encouraging consumption
- Both measures increase aggregate demand, helping to close the deflationary gap and restore full employment