Why is there an inflationary gap?
The inflationary gap is the difference between the actual gross domestic product (GDP) and GDP levels.
How to Read an Inflationary Gap
When the demand for goods and services exceeds production, it’s called a price gap. This can happen when there are more jobs, more trade, or higher government spending. A price gap may exist when the real GDP is higher than the potential GDP.
Inflationary Gap = Actual GDP – Expected GDPInflationary Gap = Actual GDP – Expected GDP
The economic gap is the part of the business cycle when people buy more goods and services, which causes the economy to grow. When demand goes up but production doesn’t keep up, prices increase to bring the market back into balance.
For the difference to be seen as inflationary, the real GDP must be higher than the potential GDP. A deflationary gap is what you call the difference between the possible GDP and the real GDP.
Finding the Real Gross Domestic Product (GDP)
GDP is a number that shows how much money the end goods and services made in a specific period are worth to people who buy them in that economy. GDP comprises goods and services that can be bought and sold. It also includes some output that can’t be bought or sold on the market, like government services for security or education.1
The real GDP is set by the goods market, as shown in the following equation from macroeconomic theory. To find the real GDP, you must first find the nominal GDP:
That is, Y=C+I+G+NXY=Nominal, whereGDPC = Spending on Consumption, I = Spending on Investment, and G = Spending by the Government (NX)The equation for Y is C+I+G+NX.Y = nominal, where GDPC = spending on ConsumptionI = Spending on Investment; G = Spending by the Government; Net Exports (NX)
To find the real GDP, we need to divide Y by D. Here, D is the GDP deflator, which considers inflation over time.
In the short term, real GDP goes up when investments, government spending, net exports, or consumption spending all go up. Real GDP is a way to measure how much the economy has grown while considering the effects of inflation and deflation. This makes the difference between real economic growth and just a change in the prices of goods and services.
How to Handle the Inflationary Gap with Fiscal and Monetary Policy
A government can use fiscal policy to help close a price gap by lowering the amount of money in the economy. To do this, the government cuts back on spending, taxes go up, bonds and other assets are issued, and transfer payments go down.
These changes to the economy’s spending situation can bring it back into balance. When there is less money in circulation, there is less desire for goods and services, which lowers inflation.
Central banks can also fight inflation with the tools they have available to them. It costs more to borrow money when the Federal Reserve (Fed) raises interest rates.
When monetary policy is tight, most people have less money to spend. This means there is less demand, and inflation goes down. When things are balanced, the Fed or another central bank can change interest rates to match.
How do you find an inflation gap?
An inflationary gap is the difference between the stated GDP number and the calculated number when all jobs are filled. It shows the difference in GDP output between what it would be with the average rate of unemployment and the actual GDP number.
When something is deflationary, it means that prices go down.
When prices of goods and services go up and people’s ability to buy things goes down, this is called inflation. When deflation occurs, the prices of most items and services go down.
What makes an inflationary gap happen?
An economic gap happens when the demand for goods and services exceeds the supply. This can happen when there are a lot of jobs, more trade, or more government spending.
How do you figure out the inflation gap?
The inflationary gap equals the difference between actual or current and expected GDP.
What Does a Recessionary Gap Mean?
An economy not at full employment is said to have a recessionary gap.
Conclusion
- The pricing gap is the difference between the real GDP and the GDP if everyone had a job.
- For the difference to be seen as inflationary, the real GDP must be higher than the potential GDP.
- Cutting back on government spending, raising taxes, selling bonds and other assets, raising interest rates, and cutting back on transfer payments are all policies that can help close an inflationary gap.
- A government may use fiscal policy to help close a price gap by lowering the amount of money moving around in the economy.
- A tight monetary strategy should make it harder for most people to get money, leading to less demand.
