Inflationary gap

3 key takeaways

• An inflationary gap arises when the actual GDP of an economy exceeds its potential GDP, causing demand-pull inflation due to excess demand.
• The gap indicates that the economy is operating above its sustainable capacity, often leading to rising prices, increased wages, and higher costs of goods and services.
• Policymakers can address an inflationary gap through contractionary fiscal or monetary policies to reduce aggregate demand and bring the economy back to its potential output level.

What is an inflationary gap?

An inflationary gap is the difference between an economy’s actual GDP and its potential GDP when the actual GDP is higher. Potential GDP, also known as full employment GDP, is the maximum output an economy can produce without triggering inflation, given its resources and technology. When actual GDP surpasses potential GDP, the excessive aggregate demand leads to inflationary pressures as the supply of goods and services cannot keep up with demand.

Causes of an inflationary gap

Excessive Aggregate Demand: When consumer spending, business investment, and government expenditures increase significantly, aggregate demand can exceed the economy’s capacity to produce goods and services.

Expansionary Fiscal Policy: Government policies that increase spending or cut taxes can boost aggregate demand, potentially creating an inflationary gap if the economy is already near full employment.

Expansionary Monetary Policy: Central banks may lower interest rates or increase the money supply to stimulate economic activity. If the economy is operating near its potential output, these policies can lead to excess demand and an inflationary gap.

Consumer Confidence: High levels of consumer and business confidence can lead to increased spending and investment, pushing actual GDP above potential GDP.

Implications of an inflationary gap

Rising Prices: The primary consequence of an inflationary gap is demand-pull inflation, where the excess demand drives up the prices of goods and services.

Increased Wages: As businesses compete for a limited supply of labor, wages tend to rise, contributing to higher production costs and further inflation.

Resource Strain: The economy’s resources, such as labor and capital, become overutilized, leading to inefficiencies and potential bottlenecks in production.

Reduced Purchasing Power: Inflation erodes the purchasing power of money, reducing consumers’ real income and potentially leading to lower standards of living.

Example of an inflationary gap

Example: Post-Recession Economic Boom

After a recession, the government implements aggressive fiscal and monetary policies to stimulate economic recovery. These policies include significant tax cuts, increased public spending on infrastructure, and low interest rates to encourage borrowing and investment. As a result, consumer spending and business investment surge, pushing the actual GDP above the potential GDP.

• Potential GDP: $1 trillion
• Actual GDP: $1.1 trillion
• Inflationary Gap: $100 billion

The excess demand leads to rising prices, higher wages, and increased costs of goods and services, creating an inflationary environment.

Addressing an inflationary gap

Contractionary Fiscal Policy: The government can reduce spending or increase taxes to decrease aggregate demand and bring the economy back to its potential output level.

Contractionary Monetary Policy: Central banks can raise interest rates or reduce the money supply to curb borrowing and spending, thereby lowering aggregate demand.

Supply-Side Policies: Measures to increase the economy’s productive capacity, such as investments in technology, education, and infrastructure, can help close the inflationary gap by boosting potential GDP.

Price Controls: In some cases, governments may implement price controls to manage inflation, though this can lead to shortages and other market distortions.

Challenges and considerations

Timing and Magnitude: Policymakers must carefully time and calibrate their interventions to avoid overcorrection, which could lead to a recession or deflationary gap.

Impact on Growth: Contractionary policies aimed at closing an inflationary gap can slow economic growth and potentially increase unemployment in the short term.

Global Factors: External factors, such as global demand fluctuations and commodity prices, can influence the domestic inflationary gap and complicate policy responses.

Public Perception: Public and business confidence can be affected by policy measures, influencing their effectiveness and the overall economic climate.

Related topics

• Demand-pull inflation
• Fiscal policy
• Monetary policy
• Aggregate demand

Explore these related topics to gain a deeper understanding of the dynamics of inflationary gaps, the tools available to policymakers, and the broader implications for economic stability and growth.