Inflationary Gap

Definition

An inflationary gap is a situation in which the actual level of real GDP exceeds the full-employment level of real GDP, leading to upward pressure on the price level and inflation. It represents a situation where aggregate demand in the economy is too high relative to the economy's productive capacity, creating excess demand that drives prices higher.

5 Must Know Facts For Your Next Test

1. The inflationary gap represents a situation where the economy is producing beyond its potential, leading to excess demand and upward pressure on prices.
2. An inflationary gap is typically caused by an increase in aggregate demand that outpaces the economy's ability to supply goods and services at the current price level.
3. The presence of an inflationary gap signals that the economy is operating above its full-employment level of output, indicating the need for contractionary fiscal or monetary policy to bring the economy back to equilibrium.
4. Closing an inflationary gap often requires policymakers to implement measures that reduce aggregate demand, such as raising interest rates or increasing taxes, in order to bring the economy back to its potential output level.
5. Failure to address an inflationary gap can lead to persistent inflation, eroding the purchasing power of consumers and potentially destabilizing the overall economic environment.

Review Questions

• Explain how the inflationary gap relates to the concept of aggregate demand in Keynesian analysis.
  • In Keynesian analysis, the inflationary gap is directly connected to the concept of aggregate demand. When aggregate demand in the economy exceeds the full-employment level of real GDP, it creates an inflationary gap, where actual output is higher than the economy's productive capacity. This excess demand puts upward pressure on prices, leading to inflation. Keynesian economists emphasize the role of government policies, such as fiscal and monetary policy, in managing aggregate demand to close the inflationary gap and maintain price stability.
• Describe the potential consequences of an unaddressed inflationary gap for the overall economy.
  • If an inflationary gap is left unaddressed, it can lead to persistent and accelerating inflation, eroding the purchasing power of consumers and destabilizing the overall economic environment. Uncontrolled inflation can discourage investment, reduce the real value of wages, and lead to a loss of confidence in the currency. This can have far-reaching consequences, such as reduced economic growth, higher unemployment, and social unrest. Policymakers must therefore act to close the inflationary gap through appropriate fiscal and monetary measures to maintain price stability and promote sustainable economic development.
• Evaluate the role of government policies in addressing an inflationary gap within the Keynesian framework.
  • Within the Keynesian framework, the government plays a crucial role in addressing an inflationary gap. Keynesian economists believe that active fiscal and monetary policies can be used to manage aggregate demand and bring the economy back to its full-employment level of output. Contractionary policies, such as raising interest rates or increasing taxes, can be implemented to reduce aggregate demand and close the inflationary gap. Alternatively, the government can use expansionary policies, such as cutting taxes or increasing spending, to stimulate demand when the economy is operating below its potential. The choice of policy tools depends on the specific economic conditions and the government's overall policy objectives in addressing the inflationary gap.

Related terms

Aggregate Demand: The total demand for all goods and services in an economy at a given time and price level.

Full Employment: A situation where everyone who wants a job can find one, and the economy is operating at its maximum sustainable output level.

Inflation: A sustained increase in the overall price level of goods and services in an economy over time.