Inflationary Gap

Definition

An inflationary gap occurs when the actual output of an economy exceeds its potential output, leading to upward pressure on prices. This situation often arises during periods of economic expansion, where demand outstrips supply, causing inflation to rise. An inflationary gap indicates that resources are being utilized beyond their sustainable limits, resulting in increased production costs and potentially unsustainable economic growth.

5 Must Know Facts For Your Next Test

1. An inflationary gap typically indicates that the economy is operating above its full employment level, which can lead to overheating.
2. In the presence of an inflationary gap, central banks may increase interest rates to cool down the economy and control inflation.
3. Government spending or increased consumer confidence can contribute to an inflationary gap by boosting aggregate demand.
4. The long-term effects of maintaining an inflationary gap can include wage-price spirals, where rising wages lead to further price increases.
5. Identifying an inflationary gap is crucial for policymakers to implement appropriate measures to stabilize the economy and prevent runaway inflation.

Review Questions

• How does an inflationary gap affect economic stability and what measures can be taken to mitigate its impact?
  • An inflationary gap can destabilize the economy by causing rising prices and potentially leading to hyperinflation if left unchecked. To mitigate its impact, policymakers can implement contractionary monetary policies, such as raising interest rates, or reduce government spending. These measures aim to decrease aggregate demand and bring the economy back towards its potential output level.
• Discuss the relationship between the inflationary gap and the Phillips Curve in terms of unemployment and inflation.
  • The Phillips Curve illustrates an inverse relationship between unemployment and inflation, suggesting that as unemployment decreases, inflation tends to increase. During an inflationary gap, lower unemployment can push wages higher, which in turn drives up production costs and consumer prices. This relationship highlights the challenge faced by policymakers in balancing low unemployment with stable price levels.
• Evaluate the long-term consequences of persisting in an inflationary gap for an economy's growth trajectory and overall health.
  • Persisting in an inflationary gap can lead to various long-term consequences such as wage-price spirals and loss of purchasing power for consumers. While short-term growth may seem favorable, the sustainability of this growth is questionable as it often results in market imbalances. Eventually, the economy may face corrections that could trigger recessions, harming overall economic health and stability.

Related terms

Aggregate Demand: The total demand for goods and services within an economy at a given overall price level and in a given time period.

Output Gap: The difference between the actual output of an economy and its potential output, indicating either an inflationary or recessionary gap.

Phillips Curve: A concept that illustrates the inverse relationship between inflation and unemployment, suggesting that lower unemployment can lead to higher inflation.