What is Inflationary Gap?
- An inflationary gap is a macroeconomic concept that measures the difference between the current level of real GDP and the gross domestic product (GDP) that would exist if an economy was operating at full employment.
- Key point to note is that for the gap to be considered inflationary, the current real GDP must be the higher than the potential GDP.
- Government fiscal policies that can reduce inflationary gap include reductions in government spending, tax increases, bond and securities issues, interest rate increases, and transfer payment reductions.
Understanding Inflationary Gap
The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The inflationary gap is so named because the relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run. Key point to note is that for the gap to be considered inflationary, the current real GDP must be the higher than the economy-at-full-employment GDP (also known as potential GDP).
Consider an economy in which the equilibrium level of income is $200 billion whereas the potential income is $100 billion. When the equilibrium income exceeds potential income, there is said to be an inflationary gap—which, in this case, is $100 billion.
The inflationary gap represents the point in the business cycle when the economy is expanding.
Due to the higher number of funds available within the economy, consumers are more inclined to purchase goods and services. As demand for goods and services increases but production has not yet compensated for the shift, prices rise to restore market equilibrium. When the potential GDP is higher than the real GDP, the gap is referred to as a deflationary gap.
The other type of output gap is the recessionary gap, which describes an economy operating below its full-employment equilibrium.
Calculating Real GDP
According to macroeconomic theory, the goods market determines the level of real GDP, which is shown in the following relationship:
- Y = real GDP
- C = consumption expenditure
- I = investment
- G = government expenditure
- NX = net exports
An increase in consumption expenditure, investments, government expenditure or net exports causes real GDP to rise in the short run. Real GDP provides a measure of economic growth while compensating for the effects of inflation or deflation. This produces a result that accounts for the difference between actual economic growth and a simple shift in the prices of goods or services within the economy.
Fiscal Policy to Manage the Inflationary Gap
A government may choose to use fiscal policy to help reduce an inflationary gap, often through decreasing the number of funds circulating within the economy. This can be accomplished through reductions in government spending, tax increases, bond and securities issues, interest rate increases and transfer payment reductions.
These adjustments to the fiscal conditions within the economy can help restore economic equilibrium. By shifting the overall demand for goods, the adjustments control the amount of funds available to consumers. As the amount of money within an economy decreases, the overall demand for goods and services also declines.
For example, if the Federal Reserve raised interest rates in response to inflationary activity, the increase would make borrowing funds more expensive. The increase in the associated expense lowers the number of funds available to most consumers resulting in lowered demand. Once equilibrium is reached, the Federal Reserve can shift interest rates accordingly.