Inflationary Gap

What is an Inflationary Gap?

In economics, an inflationary gap refers to the positive difference between the real GDP and potential GDP at full employment. The concept was invented by John Maynard Keynes to help identify the economy’s position in the business cycle.

Understanding Inflationary Gap

An inflationary gap requires two common macroeconomic variables: GDP and unemployment.

Gross domestic output (GDP) measures the economic output over a specific time frame. Potential GDP refers to the GDP achievable if the economy was operating at full employment.

Contrary to popular belief, full employment does not mean zero unemployment. Rather, it implies the absence of demand-deficient unemployment – the involuntary unemployment as a result of a contraction period.

Full unemployment still contains other types of unemployment inherent in market economies, such as structural unemployment and frictional unemployment. Structural unemployment exists where there is an imbalance of jobs available and workforce skill levels. In contrast, frictional unemployment is temporary unemployment due to workers quitting their jobs to find new ones.

GDP can be understood as the aggregate supply in the economy. It constantly fluctuates in the short term but always reverts to long-term mean growth, as illustrated by the orange line in the graph below.

The business cycle represents the fluctuations in GDP, and the inflationary gap occurs when the business cycle is in the expansionary period. On the other hand, a recessionary gap is when the difference between the real GDP and potential GDP is negative, corresponding to the contraction period in the business cycle.

Inflationary Gap Economics

In the short run, aggregate supply is upwards sloping because companies are willing to increase supply when prices increase. However, in the long run, aggregate supply is vertical because supply is not related to price but rather the economy’s available resources.

The long-run aggregate supply (LRAS) is stabilized at the potential GDP with full employment. The real GDP is denoted as the intersection of short-run aggregate supply (SRAS) and aggregate demand (AD).

When there is an inflationary gap, the short-run aggregate supply intersects the aggregate demand to the right of the long-run aggregate supply. The positive difference between the real GDP and the potential GDP on the x-axis is the inflationary gap.

On the other hand, when there is a recessionary gap, the short-run aggregate supply intersects the aggregate demand to the left of the long-run aggregate supply, and the difference between the real GDP and potential GDP is negative.

As theorized by economists, the fundamental cause of inflationary gaps is expansionary monetary policy. As the central bank spurs the economy, the excess demand in the short run pushes price levels up to create inflation. To meet the increased demand, suppliers increase inputs and human capital, creating an expansionary economic period.

However, if the business cycle deviates too far from the mean, the consequences are an extremely volatile economy with very high peaks accompanied by very low troughs. To ensure economic stability, the government intervenes through monetary and fiscal policy to guide the economy towards equilibrium.

If the government wishes to decrease the inflationary gap, it can influence the demand side with contractionary monetary policy by raising interest rates and decreasing the money supply. From the supply side, they can implement contractionary fiscal policy through increasing taxes and decreasing government expenditure. The combined economic policies will cool down unsustainable economic growth and prevent severe recessions.

Additional Resources

CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Aggregate Supply and Demand
• New Keynesian Economics
• Nominal GDP vs. Real GDP
• Structural Unemployment
• See all economics resources