Inflationary Gap

Published Oct 25, 2023

Definition of Inflationary Gap

An inflationary gap occurs when the level of aggregate demand in an economy exceeds its potential output, leading to upward pressure on prices. In simple terms, it is a situation where there is too much demand chasing too few goods and services, resulting in inflationary pressures.

Example

Let’s consider a hypothetical economy that is currently operating below its potential output level. Due to various factors such as increased consumer confidence, government stimulus, or low interest rates, aggregate demand starts to rise. This increased demand leads to an increase in production and employment as businesses try to meet the growing demand. However, as resources become scarce and production reaches its maximum capacity, firms may struggle to keep up with demand.

As a result, prices begin to rise, and inflationary pressures build up. Consumers, expecting future price increases, may also increase their spending, further exacerbating the situation. This creates an inflationary gap, where the actual level of output exceeds the economy’s productive capacity, leading to increasing prices and rising inflation.

Why Inflationary Gap Matters

Understanding the concept of an inflationary gap is crucial for policymakers and central banks in managing the overall health of an economy. It allows them to identify and monitor situations where excess demand could lead to inflationary pressures. By recognizing the existence of an inflationary gap, policymakers can implement appropriate measures to tame inflation and stabilize the economy, such as raising interest rates, reducing government spending, or implementing tighter monetary policies. Failure to address an inflationary gap can lead to runaway inflation, eroding purchasing power, and negatively impacting overall economic stability.