What is an Inflationary Gap?

An inflationary gap is an output gap that signifies the difference between the actual GDP and the anticipated GDP at an assumption of full employment in any given economy.

Inflationary Gap = Real or Actual GDP – Anticipated GDP

There are two types of GDP gaps or output gaps. While the inflationary gap is one, the recessionary gap is the other. An inflationary gap can be understood as the measure of excess aggregate demand over aggregate potential demand during full employment. A recessionary gapRecessionary GapRecessionary Gap is the difference between real GDP and potential GDP at the full employment level. Real GDP is always outweighed by potential GDP because the aggregate output of the economy is always lower than the aggregate output.read more is an economic state where the real GDP is out-weighted by the potential GDP under full employment.

John Maynard Keynes is regarded to have brought the modern definition of the inflationary gap.

Components of the Inflationary Gap

It comprises real gross domestic product and anticipated gross domestic product.

If X is the real GDP and Y is the GDP with full employment, then X – Y denotes the inflationary gap. The following factors are taken into account with short descriptions of their usage to determine the real GDP of an economy: –

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  • Government Expenditure: It includes social benefit transfers, all public consumption, income transfers, etc.Consumption Expenditure: It has household licenses, permits, the output of unincorporated enterprises, etc.Net exports Net ExportsNet exports of any country are measured by calculating the value of goods or services exported by the home country minus the value of the goods or services imported by the home country. It includes various goods and services exported and imported by the government, like machinery, cars, consumer goods.read more (exports – imports): Trade surplus if exports exceed imports, trade deficit if imports exceed exports.Investments: Commercial expenses (incl. equipment) exclude exchange of assets; purchase of financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more.

One should note that any intermediate products and services are not counted toward GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more formation.

Examples of Inflationary Gap & its Graph

The following are examples of the inflationary gap: –

Example #1

The real gross domestic product (GDP) of an economy in Africa is $100 billion. The anticipated GDP is $92 billion. Determine the nature and magnitude of the output gap.

Solution

The real GDP exceeded the anticipated GDP. Hence, it is an inflationary gap. Also, it can calculate this gap by subtracting the expected GDP from the real GDP of the economy.

  • = $100 billion – $92 billion= $8 billion

Thus, an inflationary gap of $8 billion can exist in the economy.

Inflationary Gap Graph

The X-axis represents national income, whereas the Y-axis signifies the expenditure.

The blue lines intersect the demand curveDemand CurveDemand Curve is a graphical representation of the relationship between the prices of goods and demand quantity and is usually inversely proportionate. That means higher the price, lower the demand. It determines the law of demand i.e. as the price increases, demand decreases keeping all other things equal.read more corresponding to the national incomes. Notice the red line sitting on the blue line (at $92 billion). That is the line of full employment. When the aggregate demand (in terms of national income) exceeds the demand under full employment conditions, the inflationary gap is caused; in this case, $8 billion.

Note that aggregate demand is the total demand for all final goods and services produced in an economy.

Example #2

A rice-producing economy gives an output of 500 tons of rice every day. Suppose that the aggregate demand for rice is 545 tons per day. What can be said about the inflationary gap in this economy?

Solution:

An inflationary gap in the given economy is,

545 tons – 500 tons = 45 tons of rice per day.

The economy utilizes its resources to generate an output of 500 tons per day. On the other hand, higher aggregate demand for rice creates an output gap of 45 tons per day. Therefore, it is possible to lower the aggregate demand by working on fiscal policy Fiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more. However, it cannot improve rice production further if surplus aggregate demand is due to the full utilization of resources.

Advantages

Below are the advantages of the inflationary gap: –

  • It is a good measure to decide economic policies. It is also useful in critically analyzing these economic policies (fiscal and monetary).If the resources of an economy are fully deployed in contribution to GDP, any signaling price rise is due to excess demand in the economy.It says it can control that inflation by checking aggregate demand.

Disadvantages

  • The excess gap between the current income, current expenditure, and current consumption is taken, whereas corresponding factors already produced in the economy are ignored in the analysis.Inflation is not a static process. It keeps on changing with improbable and varying degrees. However, the inflationary gap study is founded on a fixed basis.The negligence of the factor market Factor MarketA factor market is a resource market that allows business firms to purchase factors of production such as land, labor, raw materials with which they produce goods and services. In simple words, it is a market for the factors of production.read more affecting the inflationary gap is a weakness of the concept.

Important Points to Note

  • It can reduce by increasing savings such that aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more is reduced.When the inflationary gap is in play, it is not easy to increase production because all resources have been utilized.If government spending, the tax generated, and securities issues are curbed, it might reduce the inflationary gap.As described in the diagram above, one should remember that the coincidence of actual income and full employment income gives rise to the absence of aggregate demand. Consequently, no significant unemploymentUnemploymentUnemployment refers to a situation where individuals capable of working seek active opportunities for work but cannot find any for various reasons.read more can exist in this situation.Banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more play their role in regulating the inflationary gap. They do this by checking the money supply in the economy.

Conclusion

The inflationary gap is an output gap, also termed the GDP gap, which functions on two indicators – real and anticipated GDP. There is an inflationary gap if the quantity of expenditure in any economy rises above national incomeNational IncomeThe national income formula calculates the value of total items manufactured in-country by its residents and income received by its residents by adding together consumption, government expenditure, investments made within the country and its net exports.read more due to full employment.

DeflationaryDeflationaryDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more fiscal policies prove helpful to the government in fighting the inflationary gap caused in an economy. It is achieved by raising taxes or reducing spending, or treasury spending. Thus, the currency in circulation is brought down to a controlled level. These types of measures are referred to as contractionary fiscal policies.

Government institutions and banks make amendments to the lending rates to affect money circulation in the economy.

To a certain extent, perhaps on the extreme side, economic policies also contain stringent provisions limiting wages and resources. However, it can be a revolutionary step that can affect the functioning of the economy in the long run. Therefore, it is essential to understand the underlying causes of inflation. Sometimes, it is good to increase domestic production; at other times, it is advisable to increase imports to satiate demand.

This article has been a guide to the Inflationary Gap definition. Here, we discuss the inflationary gap example, formula, graph, advantages, and disadvantages. You may learn more about our articles below on economics: –

  • Headline InflationReflationInflation ExpectationsGDP Per Capita Calculation