Inflationary Gap

What is an Inflationary Gap?

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 is composed of two factors viz, 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. In order to determine the real GDP of an economy, the following factors are taken into account with short descriptions on their usage:

Components of Inflationary gap

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For eg:
Source: Inflationary Gap (wallstreetmojo.com)

It should be noted that any intermediate products and services are not counted toward GDP formation.

Examples of Inflationary Gap & its Graph

The following are the examples of the inflationary gap.

You can download this Inflationary Gap Excel Template here – Inflationary Gap Excel Template

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, this gap can be calculated by subtracting anticipated GDP from the real GDP of the economy.

 Inflationary Gap Example 1
  • = $100 billion – $92 billion
  • = $8 billion

Thus, an Inflationary gap of $8 billion can be seen to exist in the economy.

Inflationary Gap Graph

Inflationary Gap Example 1-2

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For eg:
Source: Inflationary Gap (wallstreetmojo.com)

The x-axis represents national income whereas the y-axis signifies the expenditure.

As apparent, the blue lines intersect 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 top of the blue line (at $92 billion). This is the line of full employment. When the aggregate demand (in terms of national income) exceeds the demand under full employment condition, 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.

Inflationary Gap Example 1-1

This is because the economy is utilizing its resources to the fullest to generate an output of 500 tons per day. On the other hand, higher aggregate demand for rice makes an output gap of 45 tons per day. It is possible to lower the aggregate demand by working on fiscal policyFiscal PolicyFiscal policy is a government policy that is used to control a country's finances and revenue, and it includes various taxes on goods, services, and individuals, i.e., revenue collection. It has an impact on spending levels, so it is referred to as monetary policy's sister policy.read more. However, the production of rice cannot be improved further if there is surplus aggregate demand due to the full utilization of resources.

Advantages

Below are the advantages of the inflationary gap.

  • It is a good measure to layout economic policies. It is also useful in the critical analysis of 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 tells that inflation can be controlled 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 study of the inflationary gap is founded on static nature basis.
  • The negligence of the factor market in affecting the inflationary gap is a weakness of the concept.

Important Points to Note

  1. It can be reduced 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.
  2. When the inflationary gap is in play, it is very difficult to increase production because all resources have been utilized.
  3. If government spending, the tax generates, securities issues are curbed, the inflationary gap might be reduced.
  4. It should be remembered that the coincidence of actual income and full employment income, as described in the diagram above, give rise to the absence of aggregate demand, and consequently no significant unemployment can exist in this situation.
  5. 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 at the GDP gap which functions on two indicators – real and anticipated GDP. 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, there is an inflationary gap.

DeflationaryDeflationaryDeflation is a decrease in the prices of goods and services caused by negative inflation (below 0%). It usually results in increased consumer purchasing power, owing to a simple supply and demand rule in which excess supply leads to lower prices.read more fiscal policies prove helpful to the government in fighting the inflationary gap caused in an economy. This is achieved by raising taxes or reducing spending or treasury spending. Thus, the amount of 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 in order 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 an extreme step that can affect the functioning of the economy in the long run. 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 has been a guide to what is an inflationary gap and its definition. Here we discuss the inflationary gap formula, its graph along with examples, advantages, and disadvantages. You may learn more about our articles below on economics –