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What Is an Inflationary Gap?
An inflationary gap is a type of economic gap where a country’s real gross domestic product is higher than its potential gross domestic product—in other words, when the real aggregate demand is higher than the projected aggregate demand if the economy were operating at full employment. This means that the citizens of the country are demanding more goods and services than the businesses can provide.
When an inflationary gap occurs, the economy is out of equilibrium level, and the price level of goods and services will rise (either naturally or through government intervention) to make up for the increased demand and insufficient supply—and that rise in prices is called demand-pull inflation.
Example of an Inflationary Gap
Most economies experience inflationary gaps naturally, as a result of the boom-bust cycle. The United States experienced an inflationary gap in 2006 when the economy was booming: unemployment was low, wage rates increased, and more households had disposable income and higher purchasing power.
This caused an increase in demand, but due to the wage increases, businesses had less money for production, causing a discrepancy between the high level of demand and the lower level of output—a textbook inflationary gap.
What Causes an Inflationary Gap?
Inflationary gaps occur when aggregate demand is higher than the projected demand, which can be caused by two different things:
- A rise in aggregate demand. A rise in demand will naturally create a discrepancy between real demand and potential demand. Excess demand can be caused by a variety of things: lower unemployment, a rise in consumer confidence, an increase in government expenditure, or an increase in private investments.
- A fall in aggregate supply. A fall in supply will also naturally create a discrepancy between real demand and potential demand. Potential causes of supply decreases include increased tariffs, wage increases, or wartime (when facilities are used for war purposes instead of producing commercial goods).
How Is an Inflationary Gap Managed?
Inflationary gaps can be managed in two main ways to bring higher price levels into market equilibrium:
- Fiscal policy. Fiscal policies are policies enacted by the government to control the money supply. To manage inflationary gaps, governments can enact contractionary fiscal policies, which reduce the money supply and therefore reduce demand. These policies can include reducing government spending and increasing taxes.
- Monetary policy. Monetary policies are policies enacted by central banks to control the money supply. To manage inflationary gaps, banks can increase interest rates to make borrowing money more difficult, therefore reducing the money supply and decreasing demand.
What Is the Difference Between Inflationary Gaps and Recessionary Gaps?
Inflationary gaps are the opposite of recessionary gaps (also called deflationary gaps), which occur when a country’s level of real GDP is lower than the potential GDP at full-employment equilibrium—in other words, when a country’s actual output is lower than the potential output at full employment level.
This occurs during times of recession when the money supply is low, consumers aren’t confident, and government spending decreases. To manage recessionary gaps, governments and central banks enact expansionary policies, which increase the money supply and therefore increase aggregate demand.
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