What is Inflationary Gap?
An inflationary gap arises when the actual Gross Domestic Product (GDP) overtakes the potential GDP within an economy. This situation indicates that the economy is operating beyond its full capacity, i.e., escalating the price level and subsequent inflationary pressures. An inflationary gap is typically instigated by an upswing in aggregate demand attributable to heightened consumption levels, increased investment, expanded government spending, or augmented net exports.
Formula Of Inflationary Gap
The following formula can measure an inflationary gap:
Inflationary Gap = Actual GDP - Potential GDP
Example of Inflationary Gap
In illustrative terms, consider an economy with an actual GDP of $10 trillion and a potential GDP of $9 trillion. The resultant inflationary gap amounts to $1 trillion, signifying an overheated economy with surplus demand for goods and services. The government can deploy contractionary fiscal or monetary measures to reduce this gap. This may encompass strategies such as diminishing government expenditures, augmenting taxes, issuing bonds, elevating interest rates, or curtailing the money supply. These policies aim to decrease aggregate demand, reinstating the economy to its full employment equilibrium