Inflationary Gap

Definition

An inflationary gap refers to a situation where aggregate demand in an economy exceeds the economy's productive capacity, leading to upward pressure on prices and inflation. It represents a disequilibrium where the level of real GDP demanded is greater than the full employment level of real GDP.

5 Must Know Facts For Your Next Test

1. An inflationary gap occurs when aggregate demand exceeds the economy's productive capacity at full employment.
2. It leads to upward pressure on prices and inflation as firms raise prices to ration scarce goods and services.
3. The inflationary gap is the difference between the equilibrium level of real GDP and the full employment level of real GDP.
4. Expansionary fiscal and monetary policies can contribute to the creation of an inflationary gap by stimulating aggregate demand.
5. Closing an inflationary gap may require contractionary policies to reduce aggregate demand and bring it in line with the economy's productive potential.

Review Questions

• How does the inflationary gap relate to the AD/AS model and its incorporation of growth, unemployment, and inflation?
  • The inflationary gap is a concept that is closely tied to the AD/AS model and its ability to explain how the economy incorporates growth, unemployment, and inflation. In the AD/AS framework, an inflationary gap arises when aggregate demand exceeds the economy's productive capacity at full employment. This disequilibrium puts upward pressure on prices, leading to higher inflation. The inflationary gap represents the difference between the equilibrium level of real GDP and the full employment level of real GDP, highlighting the economy's inability to meet the level of demand with its current productive potential. Understanding the inflationary gap is crucial for analyzing how the AD/AS model can be used to explain macroeconomic fluctuations and the policy responses needed to address them.
• Describe how the inflationary gap relates to Keynesian analysis of aggregate demand.
  • In Keynesian analysis, the inflationary gap is a key concept that helps explain the role of aggregate demand in determining the overall level of economic activity and inflation. Keynesian economists believe that the economy can experience periods of insufficient aggregate demand, leading to unemployment and underutilization of resources. However, the inflationary gap represents a situation where aggregate demand exceeds the economy's productive capacity at full employment. This excess demand puts upward pressure on prices, leading to inflation. Keynesian analysis suggests that the government and central bank can use fiscal and monetary policies to manage aggregate demand and close the inflationary gap, ultimately stabilizing the economy and promoting full employment without high inflation.
• Evaluate how the inflationary gap can be used to understand the macroeconomic implications of growth, unemployment, and inflation in an economy.
  • The inflationary gap is a powerful concept that allows us to understand the complex interplay between growth, unemployment, and inflation in an economy. By analyzing the gap between the equilibrium level of real GDP and the full employment level of real GDP, we can identify when the economy is producing beyond its productive capacity, leading to inflationary pressures. This understanding is crucial for policymakers who must balance the goals of promoting economic growth, maintaining full employment, and controlling inflation. An inflationary gap signals that the economy is overheating, and contractionary policies may be needed to cool it down and bring aggregate demand in line with the economy's productive potential. Conversely, a recessionary gap indicates a need for expansionary policies to stimulate demand and move the economy towards full employment. Overall, the inflationary gap provides a framework for analyzing the macroeconomic tradeoffs and policy responses required to achieve sustainable economic stability.

Related terms

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

Aggregate Supply: The total quantity of goods and services that firms are willing to sell at different price levels in an economy.

Full Employment: The level of employment where everyone who wants a job has one, and the economy is producing at its potential.