How to Calculate an Inflationary Gap
An inflationary gap equals actual real GDP minus potential real GDP: the amount by which output runs above full employment.
The Inflationary Gap formula
Calculator
Enter actual and potential real GDP to size the inflationary gap and the spending cut that closes it.
Short-run equilibrium output, where aggregate demand meets short-run aggregate supply.
Output at the natural rate of unemployment, shown by vertical long-run aggregate supply.
Sets the spending multiplier used to size the contractionary fix.
Output runs $36B above full employment, so firms bid up wages and input prices.
- Gap as a percent of potential GDP
- 4%
- Spending multiplier
- 4
- Government spending cut needed
- $9B
- Common mistake: gap times multiplier
- $144B
- Output status
- Inflationary gap
The dollar gap divided by potential GDP, which is the benchmark the economy is measured against.
1 divided by (1 minus MPC). It goes in the denominator of the policy calculation.
Cutting $9B of government spending pulls GDP back by the full $36B once the multiplier runs its course.
Multiplying instead of dividing calls for $144B of cuts, far more than the $36B gap needs. The multiplier belongs in the denominator.
How to calculate Inflationary Gap, step by step
- 1Find potential real GDP. Potential GDP is the output level at the natural rate of unemployment, shown by vertical long-run aggregate supply.
- 2Find actual real GDP. Read the short-run equilibrium where aggregate demand meets short-run aggregate supply.
- 3Subtract potential from actual. Inflationary gap = actual − potential, and the result is positive only when output exceeds potential.
- 4Convert to a percent if needed. Divide the dollar gap by potential GDP and multiply by 100.
- 5Size the contractionary fix. Divide the gap by the spending multiplier to find how far government spending must fall.
Worked example: Inflationary Gap
Suppose actual real GDP is $936B and potential real GDP is $900B. The inflationary gap = 936 − 900 = $36B, or 36 ÷ 900 = 4% above potential. With MPC = 0.75 the spending multiplier is 1 ÷ 0.25 = 4, so a spending cut of 36 ÷ 4 = $9B closes the gap. Multiplying instead would call for $144B of cuts, far more than the gap requires.
Inflationary Gap questions
How is an inflationary gap different from a recessionary gap?
An inflationary gap is actual GDP above potential (actual − potential), while a recessionary gap is actual GDP below potential (potential − actual). Both are measured in real dollars.
Why does an inflationary gap push the price level up?
Producing above potential means firms compete for scarce labor and inputs, bidding up wages and input prices until short-run aggregate supply shifts left and output falls back to potential.
Do you multiply or divide the gap by the multiplier?
Divide. Each dollar of the spending change is amplified by the multiplier, so the policy change equals gap ÷ multiplier.
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