Explain how a deflationary gap might occur.

Using the monetarist/new classical model and the Keynesian model, discuss the view that increases in aggregate demand will inevitably be inflationary.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definition of deflationary gap
• Keynesian or monetarist/new classical diagram to show a macroeconomic equilibrium at a level of real output below the full employment level
• explanation of factors (events) that may depress the aggregate demand and lead to a macroeconomic equilibrium at a level of real output below the full employment level
• examples of countries that have experienced a deflationary gap.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definitions of inflation, inflationary, aggregate demand (AD), monetarist/new classical model, Keynesian model
• diagrams to show the impact of an increase in AD in the two different models
• explanation why in the monetarist/new classical model an increase in AD will be inflationary
• examples of cases where an increase in AD either has or has not been inflationary
• synthesis and evaluation (discuss).

Discussion may include: consideration of an increase in AD not being inflationary in the Keynesian model if the economy is operating with spare capacity, consideration of an increase in AD not being inflationary in the monetarist/new classical model if the economy is recovering from equilibrium below the full employment level of output, consideration of the impact of simultaneous improvements on the supply side of the economy as AD increases, a consideration of the word “inevitably”, a consideration of the word “inflationary” in the context of the AD/AS model.

Award a maximum of level 2 if the response considers either the monetarist/new classical model or the Keynesian model (but not both).

Opinions or conclusions should be presented clearly and should be supported by appropriate examples.

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

The majority of candidates were able to define deflationary gap and explain how a decrease in aggregate demand would lead to equilibrium at a level of real output below the full employment level of output. The candidates which provided better answers were able to link their answer to the components of aggregate demand but often could not give plausible reasons why any of the components would decrease. In the best answers the candidates were able to give such reasons due to their knowledge of historical episodes where aggregate demand has decreased because of specific events in the economy. Unfortunately, some candidates focused on explaining deflation and their explanations, even though they were correct, were considered only marginally relevant given the specific demands of the question.

This question part provided candidates with excellent opportunity to explore the assumptions and the world views behind the two major macroeconomic models – the Keynesian and the monetarist/new classical models. While the great majority of candidates were able to draw diagrams to illustrate both models, many candidates struggled to explain the diagrams in detail and apply them to answer the question. Even in cases where the diagrams were dynamic in nature, and seemed promising at first sight, the explanations were either vague or superficial. Some candidates tried to combine both paradigms in a single diagram but the result was either an incomplete answer or a complete but rather complex diagram that was confusing for both candidate and examiner. Combining the two models in a single diagram to answer this question is, generally, not a good idea because of the subtle differences between the meaning of “full employment” in the monetarist/new classical and the traditional Keynesian world view.