Beyond this point deflation sets in; national output exceeds the expenditures on consumption, investment and that of government as well as ability to finance export. The difference between the national output given by Y and that of expenditure E is termed deflationary gap. Any gap that exists before the equilibrium level is called the inflationary gap. The existence of this disequilibrium means an excess saving over investment or more withdrawals than injections because economic participants actually spend less than the amount of income they earned hence, accumulation of inventories. This unwanted accumulation of inventories implies that firms will cut back on production, lay off workers, and income falls. Because income and consumption fall, and firms cut production whereby the actual inventories will be equal to planned inventories and planned spending equal to income at Equi. level"3
Basically, there are two main policies that can be used to close deflationary gap. They are monetary policy and fiscal policy. Monetary policy is used to influence interest rates, inflation and credit availability through changes money supply in the economy. There are three tools through which this policy can be implemented: reserve requirement, open market operations and discount rate.4 On the other hand, fiscal policy involves the use of government expenditure and taxation to influence national output and expenditure. In this section, discussion will be centered on deflationary gap experience of Japan and United States, and Ethiopia.
In the late 1990s, Japanese economy underwent a severe deflation resulting in weak demand, high unemployment rate, and steady reduction in the general price level. The country experienced steady reduction in both nominal and real GDP growth in fiscal 1923 after the Great Kanto Earthquake and in fiscal 1998, after the year in which Yamaichi Securities and Hokkaido Takushoku Bank collapsed.5 There is a belief that shifts from profit maximization to strengthening balance sheet which disrupts normal working of the economy perhaps the corporate sector stop borrowing the funds the household saved even with very low interest6. (Nakahara) says that the application of monetary policy brought about considerable improvement in the economy. Bank of Japan adopted the Zero Interest Rate Policy from February 1999 to August 2000 when the industrial sector grew considerably well; corporate profits were recovering, business fixed investment and private consumption were on the rise7. In addition, the Bank of Japan introduced open market operations with overall objective of tackling reducing interest rate. The bank planned more liquidity to be made available in the money market by maintaining the outstanding balance of current accounts at the bank at over 6 trillion yen and targeting interest rate below 0.01 percent.
In the diagram below, the effect of changes in interest rate is employed by Bank of Japan in order to tackle deflation. At point E the economy is at equilibrium national product which is less than full employment. Point B represents the national output the economy produces where equilibrium exists at point E intersection of initial aggregate demand AD1 and national product NP while point F is the anticipated full employment output the