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Inflationary Gap

What Does Inflationary Gap Mean?


A macroeconomic condition that describes the distance between
the current level of real gross domestic product (GDP) and full
employment (long run equilibrium) real GDP. 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.
Investopedia explains Inflationary Gap
According to macroeconomic theory, the goods market
determines the level of real GDP, which is shown in the following
relationship:

An inflationary gap, in economics, is the amount by which the real


Gross domestic product, or real GDP, exceeds potential GDP.[1] The real
GDP is also known as GDP "adjusted for inflation", "constant prices"
GDP or "constant dollar" GDP, because it measures the aggregate
output in a country's income accounts in a given year, expressed in
base-year prices. On the other hand, the potential GDP is the quantity
of real GDP when a country's economy is at full-employment.
When an initial increase in aggregate demand produces inflation (so
called demand-pull inflation) and real GDP increase, the price level and
real GDP are determined at the point where the new aggregate demand
and the short-run aggregate supply meet. This point is known as above
full-employment equilibrium[1], since the short-run aggregate supply
is above the long-term aggregate supply, i.e. above the aggregate
supply at full employment. The gap created between real GDP and
potential GDP is the consequence of inflation, this is one of the reasons
this type of gap is called an inflationary gap.
Obviously, this situation cannot last forever, because there is a shortage
of labour. The shortage of labour produces the rise of wage rates, which
makes the short-run aggregate supply decrease, until it reaches the fullemployment level. The short-run aggregate supply decrease makes an
upward pressure on the price level, consequently causing inflation. The
once created gap between real GDP and potential GDP was the sign of
forthcoming inflation, this is another reason this type gap is called an
inflationary gap. See also Recessionary gap.

When aggregate demand exceeds aggregate supply, thus causing prices


to increase if the economy is at full employment, or bringing about
increases in production if it is not. It is usually attributed to government
operating on deficit, thereby spending more than it receives in taxes
and, so, creating excess demand.

When aggregate demand exceeds an economy's productive


potential there is an inflationary gap. We tend to see rising
inflation and a worsening trade situation at these times. This
situation occurs when the economy has been growing for some
time leading to a build up of inflationary pressure as demand
rises. In the late 1980s there was a cyclical boom in the
economy that led to a large inflationary gap. Consumer demand
increased by over 7.5% in real terms during 1988 and the
economy was clearly over-heating with demand running ahead
of the ability of the economy to supply goods and services.

Controlling an inflationary gap


The government may use monetary and or fiscal policy to help
reduce the size of the inflationary gap. This would involve
controlling total spending by either increasing interest rates or
raising taxation.
An improvement in the supply-side performance of the
economy
would
also
achieve
this.
Monetary Policy: Higher interest rates to curb consumer
demand
Fiscal Policy: A rise in the burden of taxation to reduce real
disposable
incomes
Supply-side Policy: Measures to increase productivity and
efficiency. This leads to a rise in aggregate supply and reduces
the amount of excess demand in the long run.
Inflationary gaps can arise when the economy has grown for a
long time on the back of a high level of aggregate demand.
Total spending may rise faster than the economy's ability to

supply goods and services. As a result, actual GDP may exceed


potential GDP leading to a positive output gap in the economy.

Over the last ten years the output gap (the estimated
difference between actual and potential GDP) has remained
very low helping to control any demand-pull inflationary
pressure in the economy. The chart above shows that following
the last recession, the output gap was negative with actual
GDP well below potential (i.e. there was plenty of spare
capacity to meet increases in aggregate demand). By the late
1990s, this output gap had eroded but the Bank of England
has striven to keep the growth of AD close to the long term
trend rate of growth and it seems to have reasonably successful
in this ambition. The output gap turned negative in 2002
following a slowdown in real GDP growth.