Inflationary Gap

Inflationary Gap

An inflationary gap occurs when an economy’s actual (real) GDP exceeds its potential (full‑employment) GDP. In this situation, aggregate demand outpaces the economy’s capacity to produce goods and services, putting upward pressure on prices.

Key takeaways

• An inflationary gap exists when Actual (Real) GDP > Potential (Full‑Employment) GDP.
• It results from demand exceeding productive capacity and tends to raise the general price level.
• Policies to reduce an inflationary gap include fiscal tightening (lower spending, higher taxes, reduced transfers) and tighter monetary policy (higher interest rates, reduced money supply).
• The opposite condition—Actual GDP < Potential GDP—is a recessionary (or deflationary) gap.

How to measure the gap

Inflationary gap = Actual (Real) GDP − Potential GDP

To compute real GDP in macroeconomic accounting:
1. Nominal GDP (Y) = C + I + G + NX
* C = consumption expenditure
* I = investment
* G = government expenditure
* NX = net exports (exports − imports)
2. Real GDP = Nominal GDP ÷ GDP deflator (to remove price level changes)

The inflationary gap can be expressed in currency units or as a percentage of potential GDP.

What causes an inflationary gap

Typical drivers include:
* Strong consumer demand (rising consumption)
High employment and rising wages that boost spending power
Increased investment or higher government expenditure
* A surge in net exports or other demand shocks

When demand grows faster than the economy’s productive capacity, output may temporarily exceed full‑employment output, creating inflationary pressure.

Economic effects

• Rising prices (inflation) as firms respond to excess demand.
• Potential overheating of labor and product markets, which can lead to unsustainable wage‑price spirals.
• If unchecked, may erode purchasing power and require policy intervention.

Policy responses

Fiscal policy (government actions)
* Reduce government spending.
Raise taxes to withdraw demand from the economy.
Reduce transfer payments (e.g., subsidies, some welfare payments).
* Issue government bonds to absorb excess liquidity.

Monetary policy (central bank actions)
* Raise interest rates to make borrowing more expensive and reduce spending.
* Implement tighter credit conditions or reduce central‑bank liquidity to lower aggregate demand.

Both tools aim to reduce aggregate demand until it aligns with potential output, restoring price stability.

Identifying an inflationary gap

Compare measured real GDP with estimates of potential GDP (full‑employment GDP). If real GDP exceeds the potential estimate, the difference is an inflationary gap. Analysts may use output gaps, labor market indicators (unemployment below the natural rate), and inflation trends to assess the gap.

Inflationary vs. recessionary gaps

• Inflationary gap: Actual GDP > Potential GDP → upward pressure on prices.
• Recessionary (or deflationary) gap: Actual GDP < Potential GDP → downward pressure on prices and underused resources.

Bottom line

An inflationary gap signals that aggregate demand is outstripping an economy’s productive capacity, leading to inflationary pressures. Governments and central banks respond with fiscal tightening and tighter monetary policy to cool demand and reestablish equilibrium between actual and potential output.