Inflationary Gap
What is Inflationary Gap?
An inflationary gap is the difference between actual real GDP and full-employment real GDP when actual exceeds full employment.
An inflationary gap occurs when an economy is producing more than its potential, leading to upward pressure on prices. This typically happens during an expansion in the business cycle. The gap represents the amount by which real GDP exceeds potential GDP.
Inflationary Gap: a worked example
Kelbourne has potential real GDP of $840B, while actual real GDP is $882B. The inflationary gap is 882 minus 840, or $42B, which is 42 ÷ 840 × 100 = 5% of potential. To close it with fiscal policy, first find the multipliers. With a marginal propensity to consume of 0.8, the spending multiplier is 1 ÷ (1 minus 0.8) = 5. Cutting government purchases by $8.4B shrinks aggregate demand by 8.4 × 5 = $42B, exactly the gap. A tax increase works through a smaller multiplier, MPC ÷ (1 minus MPC) = 0.8 ÷ 0.2 = 4, so taxes must rise by 42 ÷ 4 = $10.5B to do the same job. The larger tax figure reflects that part of any tax change is absorbed by saving rather than spending.
The mistake students make with inflationary gap
The gap itself gets treated as the required change in spending. Facing a $60B inflationary gap, students cut government purchases by $60B, which is tempting because the two numbers seem to line up. Each dollar of spending change moves aggregate demand by more than a dollar, so divide the gap by the multiplier first. With an MPC of 0.75 the multiplier is 4, and closing a $60B gap takes only a $15B cut. Cutting the full $60B would overshoot badly and drop the economy into a recessionary gap.
Inflationary Gap questions
How do you calculate an inflationary gap?
Subtract potential real GDP from actual real GDP in the case where actual is the larger number. Actual output of $1.05 trillion against potential of $1.00 trillion gives an inflationary gap of $50 billion. On an aggregate demand and aggregate supply diagram the gap is the horizontal distance between short-run equilibrium output and the vertical long-run aggregate supply curve, measured to the right of full employment.
What happens to unemployment during an inflationary gap?
Unemployment falls below the natural rate. Firms producing beyond their sustainable capacity bid aggressively for scarce workers, overtime hours climb, and cyclical unemployment turns negative. That competition pushes nominal wages up, which raises production costs and eventually shifts short-run aggregate supply left, returning output to potential at a higher price level. The temporary output boost is paid for with a permanently higher price level.
How does an economy close an inflationary gap on its own?
Self-correction runs through the labor market. With output above potential, workers negotiate higher nominal wages to keep up with rising prices, and firms face higher input costs. Short-run aggregate supply shifts left, real GDP slides back to potential, and the price level ends up higher than where it started. The process needs no policy action, though economists disagree about how long the wage adjustment takes.
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