What is an Inflationary Gap?
An inflationary gap measures the difference between the current level of real Gross Domestic Product (GDP) and the GDP that would exist if an economy was operating at full employment.
Key Takeaways
- An inflationary gap measures the difference between the current real GDP and the GDP of an economy operating at full employment.
- The current real GDP must be higher than the potential GDP for the gap to be considered inflationary.
- Policies to reduce an inflationary gap include reductions in government spending, tax increases, bonds, securities issues, interest rate increases, and transfer payment reductions.
- A government may use fiscal policy to help reduce an inflationary gap by decreasing the funds circulating within the economy.
- A tight monetary policy should lower the money available to most consumers, triggering less demand.
What Defines an Inflationary Gap?
An inflationary gap exists when the demand for goods and services exceeds production due to higher levels of employment, increased trade activities, or elevated government expenditure. The real GDP can exceed the potential GDP, resulting in an inflationary gap:
[ Inflationary\ Gap = Actual\ GDP - Anticipated\ GDP ]
This points to a stage in the business cycle when the economy expands, but production can’t keep up with the growing demand. With increased demand and limited supply, prices escalate, restoring market equilibrium.
Calculating Real Gross Domestic Product (GDP)
GDP measures the monetary value of all final goods and services produced within an economy during a specific period. Real GDP adjusts this value for inflation, providing a clear measure of economic growth.
Formula for Real GDP:
First, calculate nominal GDP:
[ Y = C + I + G + NX ]
- Y: Nominal GDP
- C: Consumption expenditure
- I: Investment
- G: Government expenditure
- NX: Net exports
Then, calculate real GDP:
[ Real\ GDP = \frac{Nominal\ GDP}{GDP\ Deflator} ]
Fiscal and Monetary Policy to Manage the Inflationary Gap
Governments employ fiscal policies to control the inflationary gap by reducing government spending and increasing taxes, bonds, and reducing transfer payments. By decreasing the funds circulating in the economy, overall demand diminishes, reducing inflation.
Central banks also combat inflation by raising interest rates, making borrowing more expensive. A ’tight’ monetary policy limits the money available to consumers, decreasing demand and easing inflationary pressures. Adjusting these interest rates accordingly can help maintain economic stability.
Key Concepts about Inflationary Gap
Identifying an Inflationary Gap
An inflationary gap represents the difference between the full-employment GDP and the actual reported GDP. This occurs when actual GDP surpasses what is naturally sustainable under normal employment levels.
Difference between Inflationary and Deflationary Gaps
Inflation implies rising prices and decreased purchasing power, while deflation represents a downward movement in the general price level of goods and services.
Causes of an Inflationary Gap
An inflationary gap can be caused by factors like high employment levels, increased trade activities, and greater government expenditure.
Calculation of the Inflationary Gap
The inflationary gap is calculated as:
[ Inflationary\ Gap = Real\ GDP - Anticipated\ GDP ]
Complementary Concept: Recessionary Gap
A recessionary gap occurs when an economy operates below its full-employment equilibrium, indicating less economic output than the potential GDP.
Conclusion
An inflationary gap measures the difference between the current real GDP and the potential GDP at full employment. Addressing this gap often involves policies that reduce government spending, increase taxes, and adjust interest rates. Understanding this economic indicator helps governments to enact measures that ensure economic stability and growth.
Related Terms: Real GDP, Potential GDP, Deflationary Gap, Recessionary Gap, Full Employment.
References
- International Monetary Fund. “Gross Domestic Product: An Economy’s All”.
