What is an Inflationary Gap?

What is an Inflationary Gap?

In economics, an inflation gap refers to the positive difference between real GDP and potential GDP at full employment. The concept was invented by John Maynard Keynes to identify the economy’s position in the business cycle.

An inflation gap refers to the positive difference between real GDP and potential GDP at full employment.

The business cycle represents fluctuations in GDP and the inflation gap occurs when the business cycle is in the expansion phase.

An inflation gap occurs in the economy when short-term aggregate supply intersects aggregate demand to the right of long-term aggregate supply.

How does an inflation gap work?

When inflation leads to higher wages, and higher wages lead to increased consumer demand, an inflation gap emerges. It is based on two economic concepts: the non-accelerating rate of inflation in employment, also known as the NAIRU or short-term natural unemployment rate, and potential GDP, a theoretical estimate of the value of output the economy would have produced if labor and capital were operating at their maximum rates used.

 The idea is that there is a trade-off between inflation and employment, which economists call the Phillips curve.

The natural rate of unemployment allows for occurrences such as new graduates entering the labor market, layoffs for non-performance, and business failures due to poor management.

When there is an increased demand for labor, employers must increase wages to attract labor, and employment levels can exceed the natural rate. When that happens, the inflation rate can accelerate. One way to study the impact of this inflation is to assess the inflation gap.

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Some of these concepts are controversial. Academic economists are constantly writing papers about the level of the natural unemployment rate and the existence of potential GDP. If you can’t calculate a natural unemployment rate, you can’t calculate an inflation gap either.

Economies are dynamic, and many of these concepts assume that they are static. That’s not bad for analysis, but it can be confusing if you’re not an economist and just want to understand what’s going on.

Suffice it for non-economists to know that inflation can be driven by labor demand, as employers need to increase wages to attract it. Because these workers earn more money, it will boost their demand for goods.

Significance Of Inflationary Gap

Effect on Income and Prices – The importance of the inflationary gap depends on its effect on the national income and prices. When an inflationary gap endures at full employment, it raises the money income of the people, but the output cannot be increased because of full employment. Hence, the inflationary gap directly leads to a rise in prices.

Non-Monetary Inflation – Keynes’ emphasis on the flow of expenditures as the cause of demand-pull inflation leads to the result that a society can have non-monetary inflation. This is quite the opposite of the view held by the quantity theorists who believed inflation is because of the excessive growth of money stock.

In Keynes’ analysis, the effect of this extreme growth of money supply may be uncertain because it will cause an inflationary increase in prices indirectly through its impact first on the rate of interest and, in turn, aggregate spending.

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Anti-Inflationary Policies- The inflationary gap manages the monetary and fiscal authorities to adopt suitable anti-inflationary measures to restrain inflationary pressures. These measures intend to affect the propensities to consume, save, and invest, which together determine the general price level.

Advantages of Inflationary Gap

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 of Inflationary Gap

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 affecting the inflationary gap is a weakness of the concept.

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 income due to full employment.

Deflationary 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.

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