The excess of Aggregate Demand above the level required to maintain equilibrium in full employment situation in an economy, is termed as inflationary gap. It causes inflation and increases price levels in an economy.
When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand from the level required to maintain a full employment equilibrium. This short fall is termed as deflationary gap. It causes reduction in prices in the economy.
Inflationary and deflationary gap can be corrected by opting following means:
(i) To correct the inflationary gap, government should form fiscal and monetary policy to close the gap. Monetary policy can be used in such a manner that it will contract the money supply in the economy by raising interest rates and opts the method of progressing taxation.
(ii) To correct the deflationary gap, government should stood doing the additional expenditure equal to deflationary gap, so that deflationary gap is wiped out.