inflationary gap

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Inflationary Gap

A situation in which the real GDP (GDP adjusted for inflation) exceeds the potential for what the economy can actually produce. This occurs when demand for products exceeds the labor or other resources required to produce them. Ultimately, this leads to demand-pull inflation.
Inflationary gapclick for a larger image
Fig. 94 Inflationary gap. (a) the AGGREGATE SUPPLY SCHEDULE is drawn as a 45-degree line because businesses will offer any particular level of output only if they expect total spending (aggregate demand) to be just sufficient to sell all that output. However, once the economy reaches the full employment level of national income (OY1 ), then output cannot expand further and at this level of output the aggregate supply schedule becomes vertical. If aggregate demand was at the level indicated by AD, the economy would be operating at full employment without inflation (at point E). However, if aggregate demand was at a higher level like AD1 this excess aggregate demand would create an inflationary gap (equal to EG), pulling price upward.

(b) Alternatively, where aggregate demand and aggregate supply are expressed in terms of real national income and price levels, an inflationary gap shows up as the difference between the price level (OP) corresponding to the full employment level of aggregate demand (AD) and the price level (OP1) corresponding to the higher level of aggregate demand (AD1) at real national income level OY 1. See DEMAND-PULL INFLATION.

inflationary gap

the excess of total spending (AGGREGATE DEMAND) at the full employment level of national income (POTENTIAL GROSS NATIONAL PRODUCT). As it is not possible to increase output further, the excess demand will cause prices to rise, that is, real output remains the same but the money or nominal value of that output will be inflated. To counter this excess spending, the authorities can use FISCAL POLICY and MONETARY POLICY to reduce aggregate demand.