The Concept of Inflationary Gap Explained

Tap to Read ➤ Neha B Deshpande

Inflationary gap is a situation wherein there is excessive demand for goods and services in the economy, as compared to its potential to supply them. This OpinionFront post gives you a brief explanation of the concept of inflationary gap.

What is Real GDP?

Real *GDP is inflation-adjusted GDP to measure the value of goods and services produced by an economy during a particular tenure.

*GDP = Gross Domestic Product GDP is the measure of value of all the finished goods and services of an economy for a particular time period.

Inflation, these days, is a word that our ears have become too accustomed to hear. Most economies are facing inflation, and also bearing the negative side effects of it.

As aptly said in this humorous and witty quote, "Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair." ― Sam Ewing , we all know that inflation is a growing menace these days.

Inflationary gap is one such terminology in economics that is defined as the gap by which the Real GDP exceeds the Potential GDP of any economy at the full employment level.

Keynesian Concept of Inflationary Gap

'How to Pay for War?'

Keynes has explained the terminology of inflationary gap in this pamphlet that was published in 1940, that mostly dealt with war finance. According to him, it is an excess of expenditure over and above the potential output.

It indicates the difference between the gross domestic product against the potential GDP at level of full employment. In simple words, it is the excess of the aggregate demand for the products and services in an economy, over the potential to provide them. Thus, such a situation arises when there is growth in the economy, due to various factors such as increased level of production, increase in employment opportunities, etc.

Reasons for Inflationary Gap

One of the primary causes for an inflationary gap is excessive demand. Demand can increase due to a myriad of factors, such as:

Rise in Employment Opportunities

A higher standard of living and rise in employment opportunities will lead to an increase in demand for household items. Certainly, with more facilities, there will be an increase in demand for consumer goods.

Increase in Trade Activities

With rising export activities, there is more money injected into the economy, which again increases the purchasing capacity of the individuals in the economy.

Increased Government Expenditure

A high level of government expenditure again, pumps more money into circulation, which leads to increased demand. An inflationary gap example is when the United States witnessed an inflationary gap phenomenon for a brief period from 2006 to 2007.

Inflationary Gap Graph

LRAS = Long Run Aggregate Supply SRAS = Short Run Aggregate Supply I = Intersection Point of SRAS and AD Curve AD = Aggregate Demand Curve Difference between Y0 and Y1 = Inflationary Gap

The LRAS curve represents the production level at the full level of employment. On the other hand, short-run equilibrium occurs at the intersection of the AD and SRAS curves. Note that this intersection is at the right of the potential GDP level.

It implies that there is an inflationary gap, since the Real GDP is higher than the Potential GDP. This gap is nothing but the inflationary gap. This indicates that at the given level, there is high demand for resources, and the economy does not have that potential to produce requisite goods and services to satisfy this demand.

If the Real GDP is lesser than the Potential GDP, the difference is said to be a deflationary gap.

Fiscal Policy Options to Reduce Inflationary Gap

To reduce the inflationary gap, the government has to introduce a contractionary fiscal policy to reduce the money circulation in the market.

Reduce Government Spending

The government has to reduce its public spending and stop pumping in more money into the market. Accordingly, the purchasing capacity of individuals will decline, and hence, there will be less demand, which will then curtail the inflationary gap.

Increase Taxes

With increase in taxes, consumers will have less money for consumption of goods and services. Thus, their demand will automatically reduce and be lesser.

Issue Bonds and Securities

By issuing government securities and bonds in the market, they can reduce the money circulation and curb the inflationary gap.

Decrease Transfer Payments

Transfer payments are made by the government for various social security and welfare programs, such as pension funds, grants, etc., for the masses. By reducing these payments, they can reduce the amount of money in the hands of the public, which will in turn reduce their purchasing capacity, and automatically reduce the demand for goods and services.

An inflationary gap eventually gets reduced over a certain period of time. While inflation cannot be said to be always harmful to the economy, many are of the opinion that some degree of inflation is good to boost the economy. Moreover, with appropriate measures, the economy can be eventually stabilized.