Inflationary gap

Inflationary gap is the amount by which actual GDP exceeds potential GDP when an economy operates above its full-employment output level (Blanchard O. 2021, p.205)^[1]. Sounds abstract until you live through it. Unemployment falls below natural rates. Factories run overtime. Workers get poached with signing bonuses. Wages spiral upward. Prices follow. The economy runs hot—too hot. Something has to give.

The gap measures overheating. When aggregate demand pushes output beyond what the economy can sustainably produce, inflation becomes inevitable. Not the slow, tolerable kind. The accelerating, destabilizing kind.

Understanding potential GDP

Every economy has a speed limit—potential GDP. This represents maximum sustainable output when resources are fully employed but not strained.

Full employment doesn't mean zero unemployment. It means unemployment at its "natural" rate—only frictional and structural joblessness remain. People between jobs, people with mismatched skills. Cyclical unemployment has vanished^[2].

Full capital utilization doesn't mean every machine runs 24/7. It means normal operating rates without breakdowns from overuse.

Potential GDP grows over time as population expands, technology improves, and capital accumulates. But at any moment, the economy has a ceiling. Push past it and problems emerge.

The mechanics

In the aggregate demand-aggregate supply framework:

• Long-run aggregate supply (LRAS) is vertical at potential GDP. The economy gravitates here eventually.
• Short-run aggregate supply (SRAS) slopes upward—higher prices coax more output temporarily.
• Aggregate demand (AD) slopes downward—lower prices increase purchasing power and demand.

An inflationary gap appears when AD and SRAS intersect to the right of LRAS. Actual output exceeds potential. The economy produces more than sustainable capacity allows^[3].

Why can't this last? Because operating above capacity creates pressures:

• Tight labor markets drive wages higher
• Overtime and rush orders increase costs
• Input shortages emerge
• Firms gain pricing power

These forces shift SRAS leftward over time. Prices rise. Real GDP falls back toward potential. The gap closes through inflation—not comfortably, but inevitably.

Measuring the gap

The output gap formula:

\[Output\\ Gap = \frac{Y - Y^*}{Y^*} \times 100\%\]

Where:

• Y = actual GDP
• Y* = potential GDP

Positive gap = inflationary gap. Negative gap = recessionary gap.

Example: If potential GDP is $20 trillion and actual GDP reaches $21 trillion, the gap is:

\[\frac{21 - 20}{20} \times 100\% = 5\%\]

The economy operates 5% above sustainable capacity. That 5% represents borrowed time—output maintained only by running resources harder than they can run indefinitely^[4].

Historical examples

United States, 1960s. Vietnam War spending and Great Society programs pushed demand beyond capacity. Unemployment fell below 4%. Inflation crept from 2% to 6% by decade's end. The inflationary gap, unaddressed, planted seeds for the 1970s stagflation.

Japan, late 1980s. The bubble economy pushed real GDP above potential for years. Asset prices soared. When correction came, it lasted decades—the inflationary gap's aftermath worse than the overheating itself.

United States, 2021-2022. Pandemic stimulus met supply chain disruptions. Demand recovered faster than supply capacity. Unemployment dropped to 3.4%. Inflation hit 9.1% by mid-2022—the largest inflationary gap since the 1970s^[5].

Causes of inflationary gaps

Several forces can push actual GDP above potential:

Expansionary monetary policy. Central banks lower interest rates, increasing borrowing and spending. Money supply grows faster than real output can absorb. Demand overwhelms supply capacity.

Expansionary fiscal policy. Government spending increases or taxes fall, boosting aggregate demand. Deficit-financed stimulus adds purchasing power without corresponding production.

External demand surge. Export booms from trading partner growth inject demand into domestic economy.

Wealth effects. Rising stock or housing prices make consumers feel richer, increasing spending beyond sustainable levels.

Optimistic expectations. Businesses and consumers simultaneously expect good times, spending and investing accordingly. Collective optimism creates its own boom—temporarily^[6].

Self-correction mechanism

In theory, inflationary gaps close automatically:

1. Output above potential creates labor shortages
2. Wages rise as firms compete for workers
3. Higher wages increase production costs
4. SRAS shifts left (less output at each price level)
5. Prices rise, reducing real demand
6. Output falls back toward potential

This adjustment takes time—months or years. Meanwhile, inflation accelerates. The longer the gap persists, the more inflation embeds into expectations, making ultimate correction more painful.

Keynesians doubt self-correction happens smoothly or quickly enough. They advocate policy intervention. Monetarists and New Classical economists trust the mechanism more, worrying that intervention creates distortions^[7].

Policy responses

When policymakers identify an inflationary gap, they face choices:

Contractionary monetary policy. The central bank raises interest rates, reducing borrowing and spending. The Federal Reserve raised rates aggressively in 2022-2023 to close the inflationary gap, accepting recession risk to restore price stability.

Contractionary fiscal policy. Government reduces spending or raises taxes. Politically difficult—nobody wants austerity during good times. Yet good times are precisely when fiscal tightening makes sense.

Doing nothing. Let the self-correction mechanism work. Accept temporary inflation as the price of previous stimulus. Risk: inflation expectations become unmoored, requiring harsher correction later^[8].

The policy dilemma: early intervention causes recession before inflation gets bad. Late intervention requires harsher measures when inflation has accelerated. No timing is painless.

Inflationary gap vs. recessionary gap

Mirror images:

	Inflationary Gap	Recessionary Gap
Output gap	Positive (Y > Y*)	Negative (Y < Y*)
Unemployment	Below natural rate	Above natural rate
Inflation pressure	Upward	Downward (or deflationary)
AD-SRAS intersection	Right of LRAS	Left of LRAS
Self-correction	SRAS shifts left, prices rise	SRAS shifts right, prices fall
Policy response	Contractionary	Expansionary

Both gaps represent disequilibrium. Both create economic distress. Inflationary gaps hurt savers and fixed-income earners through rising prices. Recessionary gaps hurt workers through unemployment. Neither is desirable^[9].

Challenges in estimation

Measuring inflationary gaps requires estimating potential GDP—which nobody observes directly.

Methods for estimating potential GDP:

• Statistical filters. Hodrick-Prescott filter smooths actual GDP to estimate trend. Simple but mechanical—no economic theory embedded.
• Production function approach. Estimate potential output from capital stock, labor force, and technology. Requires assumptions about each input.
• NAIRU-based estimates. Infer potential GDP from relationship between inflation and unemployment. If inflation accelerates, output probably exceeds potential.

Different methods yield different estimates. The Congressional Budget Office's potential GDP estimate for 2022 differed from private sector estimates by hundreds of billions. When measurement uncertainty exceeds the gap itself, policy becomes guesswork^[10].

The Phillips Curve connection

The Phillips Curve relates inflation to unemployment—and by extension, to output gaps.

• Inflationary gap → unemployment below natural rate → inflation accelerates
• Recessionary gap → unemployment above natural rate → inflation decelerates

This relationship, once thought stable, broke down in the 1970s (stagflation: high inflation with high unemployment) and puzzled economists in the 2010s (low unemployment without inflation).

The modern view: the relationship holds but expectations matter. An inflationary gap creates inflation pressure, but actual inflation depends on whether people expect it. Anchored expectations delay inflation; unanchored expectations accelerate it^[11].

Supply-side considerations

Not all above-potential output represents demand excess. Supply shocks can temporarily increase potential:

• Technological breakthroughs raising productivity
• Immigration expanding labor force
• Regulatory reform reducing production costs

These positive supply shocks shift LRAS rightward, possibly faster than AD grows. The economy can sustain higher output without inflation. The late 1990s showed this—productivity gains from IT allowed strong growth with low inflation.

Distinguishing demand-driven inflationary gaps from supply-driven sustainable expansion challenges policymakers. Tightening policy against supply-driven growth wastes opportunity.

Inflationary gap — recommended articles

Economic trend — Monetary policy — Macroeconomics — Fiscal policy

References

• Blanchard O. (2021), Macroeconomics, 8th Edition, Pearson, Boston.
• Mankiw N.G. (2020), Macroeconomics, 10th Edition, Cengage Learning, Boston.
• Mishkin F.S. (2019), The Economics of Money, Banking, and Financial Markets, 12th Edition, Pearson, Boston.
• Congressional Budget Office (2023), The Budget and Economic Outlook: 2023 to 2033, CBO, Washington.

Footnotes

1. ↑ Blanchard O. (2021), Macroeconomics, p.205
2. ↑ Mankiw N.G. (2020), Macroeconomics, pp.278-292
3. ↑ Blanchard O. (2021), Macroeconomics, pp.208-220
4. ↑ Congressional Budget Office (2023), Budget and Economic Outlook
5. ↑ Mishkin F.S. (2019), The Economics of Money, pp.567-582
6. ↑ Mankiw N.G. (2020), Macroeconomics, pp.312-328
7. ↑ Blanchard O. (2021), Macroeconomics, pp.235-248
8. ↑ Mishkin F.S. (2019), The Economics of Money, pp.598-615
9. ↑ Mankiw N.G. (2020), Macroeconomics, pp.356-372
10. ↑ Congressional Budget Office (2023), Budget and Economic Outlook
11. ↑ Blanchard O. (2021), Macroeconomics, pp.267-285

Author: Sławomir Wawak