Inflationary gap

Inflationary gap
See also
Disinflation Ratchet effect Imported inflation Stabilization policy Reflation Demand-pull inflation Currency depreciation Income effect Underconsumption

Inflationary gap is the difference between the actual output of an economy and the potential output of an economy at the full employment level. It is the amount of output that is lost due to an economy not being able to reach full employment. The greater the gap, the higher the rate of inflation.

Inflationary gaps can occur when the demand for goods and services are greater than the production capacity of an economy. This can lead to an increase in prices as the demand for goods and services increase, while the production capacity remains the same. This can create an imbalance in the economy, as the increased demand leads to more money chasing fewer goods, resulting in an increase in prices.

Inflationary gaps can be caused by a number of factors, including:

• Increase in government spending: When governments increase spending, it can lead to an increase in demand for goods and services, which can cause an inflationary gap.
• Increase in exports: When an economy increases its exports, it can lead to a decrease in the supply of goods and services in the domestic market, which can lead to an inflationary gap.
• Increase in investment: When businesses increase their investment, it can lead to an increase in demand for goods and services, which can create an inflationary gap.

In order to calculate the inflationary gap, one must use the following formula: Inflationary Gap = Actual GDP - Potential GDP.

The inflationary gap can have a variety of impacts on an economy. If the inflationary gap is too large, it can lead to high inflation and a decrease in economic growth. On the other hand, if the gap is too small, it can lead to deflation and a decrease in economic growth.

Overall, inflationary gap is the difference between the actual output of an economy and the potential output of an economy at the full employment level. It is caused by an imbalance between demand and supply of goods and services, and can have a range of impacts on an economy.

Example of Inflationary gap

Let’s say the actual output of an economy is 100 and the potential output at full employment is 120. Then, the inflationary gap would be the difference between the two numbers, which is 20. This means that the economy is not able to produce at its full potential and is losing 20 units of output due to an imbalance between demand and supply.

Formula of Inflationary gap

Inflationary Gap = Actual GDP - Potential GDP.

When to use Inflationary gap

Inflationary gaps are most commonly used by governments and central banks to measure the performance of an economy and to assess the potential for inflation. It can also be used to measure the potential for economic growth and to help formulate economic policies. Inflationary gaps can also be used to measure the potential for deflation and to help guide monetary policies.

Types of Inflationary gap

Inflationary gap can be classified into two types:

• Positive Inflationary Gap: This type of gap occurs when the actual output of the economy is greater than the potential output at full employment. This leads to an increase in prices, as the increased demand for goods and services causes an increase in prices.
• Negative Inflationary Gap: This type of gap occurs when the actual output of the economy is less than the potential output at full employment. This leads to a decrease in prices, as the decreased demand for goods and services causes a decrease in prices.

Steps of Inflationary gap

1. Calculate the difference between the actual output of an economy and the potential output of an economy at the full employment level using the formula: Inflationary Gap = Actual GDP - Potential GDP.
2. Assess the impact of the gap on the economy. If the gap is too large, it can lead to high inflation and a decrease in economic growth. On the other hand, if the gap is too small, it can lead to deflation and a decrease in economic growth.
3. Identify the possible causes of the gap. These can include an increase in government spending, exports, or investment.
4. Take steps to address the gap. This can include decreasing government spending, increasing exports, or stimulating investment.

Advantages of Inflationary gap

• Stimulates economic growth: Inflationary gap can stimulate economic growth by encouraging businesses to invest in new equipment and hire more workers.
• Increases employment: Inflationary gap can lead to an increase in employment, as businesses will be incentivized to hire more workers to meet the increased demand for goods and services.
• Increases wages: Inflationary gap can lead to an increase in wages, as businesses will be more willing to pay higher wages in order to attract workers.

Limitations of Inflationary gap

Inflationary gap is a useful tool for understanding how the economy is performing, however it does have some limitations.

• It does not take into account changes in the exchange rate, which can have a significant impact on the economy.
• It does not account for changes in the supply of money, which can also have an impact on the economy.
• It does not take into account the effects of government policies, such as taxes and subsidies, which can have an effect on the economy.

Overall, while inflationary gap can be a useful tool for understanding how the economy is performing, it does have some limitations which should be taken into account.

Other approaches related to Inflationary gap

In addition to calculating the inflationary gap, there are a number of other approaches that can be taken to understand and manage the impacts of an inflationary gap. These include:

• Monetary policy: The Central Bank can use a variety of monetary policy tools, such as controlling interest rates and increasing or decreasing the money supply, to manage the inflationary gap.
• Fiscal policy: Governments can use a variety of fiscal policy tools, such as taxes, spending, and transfers, to manage the inflationary gap.
• Supply-side policies: Governments can use a variety of supply-side policies, such as reducing taxes and regulations, to increase the supply of goods and services and reduce the inflationary gap.

Overall, there are a number of approaches that can be taken to understand and manage the impacts of an inflationary gap. These include various monetary and fiscal policy tools, as well as supply-side policies.

Suggested literature

• Cogley, T., Primiceri, G. E., & Sargent, T. J. (2010). Inflation-gap persistence in the Us. American Economic Journal: Macroeconomics, 2(1), 43-69.