Inflationary Gap

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What is an 'Inflationary Gap'

An inflationary gap is a macroeconomic concept that describes the difference between the current level of real gross domestic product (GDP) and the anticipated GDP that would be experienced when an economy is at full employment, also referred to as the potential GDP. For the gap to be considered inflationary, the current real GDP must be the higher of the two metrics.

BREAKING DOWN 'Inflationary Gap'

The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. 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.

Due to the higher number of funds available within the economy, consumers are more inclined to purchase goods and services. As the demand for goods and services increases but production has yet to compensate for the shift, prices rise in order to restore market equilibrium. When the potential GDP is higher than the real GDP, the gap is referred to as a deflationary gap.

Calculating the Real GDP

According to macroeconomic theory, the goods market determines the level of real GDP, which is shown in the following relationship:

Y = C + I + G + NX

Where Y = Real GDP

C = Consumption expenditure

I = Investment

G = Government expenditure

NX = Net exports

As illustrated above, an increase in consumption expenditure, investments, government expenditure or net exports causes real GDP to rise in the short run.

Real GDP provides a measure on economic growth while compensating for the effects of inflation or deflation. This produces a result that accounts for the difference between actual economic growth and a simple shift in the prices of goods or services within the economy.

Fiscal Policy to Manage the Inflationary Gap

A government may choose to use fiscal policy to help reduce an inflationary gap, often through decreasing the number of funds circulating within the economy. This can be accomplished through reductions in government spending, tax increases, bond and securities issues, interest rate increases and transfer payment reductions.

These adjustments to the fiscal conditions within the economy can help restore economic equilibrium by shifting overall demand for goods by controlling the amount of funds available to consumers. As the amount of money within an economy decreases, the overall demand for goods and services also declines.

For example, if the Federal Reserve raised interest rates in response to inflationary activity, the increase would make borrowing funds more expensive. The increase in the associated expense lowers the number of funds available to most consumers, resulting in lowered demand. Once equilibrium is reached, the Federal Reserve can shift interest rates accordingly,