Inflationary Gap

What Is an Inflationary Gap?

In 1940, economist Keynes used the inflationary gap(i-gap) to explain inflation. He asserts that this gap develops when total demand exceeds total supply at the income level of full employment.

This suggests that while revenues grow as a result of increased investment and spending by the government, production stays the same because of capacity restrictions.

As a direct consequence of this, an inflationary gap emerges, which causes a shortage of supply and subsequent price increases. As long as there is this gap, there will be more upward pressure on prices.

When a government chooses to support routine spending during times of full employment by raising money in circulation, an inflationary gap is created.

However, a considerable portion of the inflationary gap can be attributed to the expenditures made by the government on war or the preparations for war.

To illustrate the concept of the gap, let us take the following example: In our hypothetical national economy, 10,000 gallons of liquor are produced each week. 

Therefore, the total weekly demand for liquor is 20,000 gallons. This indicates a weekly inflationary gap of 10,000 gallons of liquor because the overall demand for liquor is greater than the real GDP at full employment. 

On the other hand, there wouldn't be an inflationary gap if the total weekly demand for liquor was only 10,000 gallons.

Significance of Inflationary Gap

Despite these concerns, the inflationary gap idea has proven to be crucial in explaining price increases at full employment levels and the effectiveness of policies in containing inflation.

It indicates that once full employment has been reached because of surplus demand brought on by rising spending.

However, the output cannot be raised because the economy has used up all its resources. The result is inflation. The difference widens as inflation picks up speed the more money is spent.

Some of the implications include

Effect On Income And Prices

The impact of the inflationary gap on prices and national income determines its relevance. The people's income rises when there is this gap at full employment, but the output cannot be raised because of full employment. 

Therefore, the inflationary gap causes an increase in prices directly.

Non-Monetary Inflation

It is concluded that a society can experience non-monetary inflation due to Keynes's emphasis on the flow of expenditures (C + I + G) as the cause of demand-pull inflation. 

The quantity theorists' belief that inflation is caused by the excessive expansion of the money stock is completely at odds with this viewpoint.

According to Keynes' reasoning, this excessive expansion of the money supply may be unknown because it will indirectly raise prices through an increase in inflation by impacting the interest rate and overall spending.

Anti-Inflationary Policies

The monetary and fiscal authorities implement suitable anti-inflationary policies to curb inflationary pressures based on the inflationary gap. 

These actions influence the tendency to consume, save, invest, and collectively determine the prices' general level.

Eliminating inflationary Gap

The i-gap caused by excessive spending can be closed by natural processes and intentional actions. However, the latter approach is more dependable and certain than the former.

Prices grow as a result of the i-gap, but the gap is not directly closed by the price increase. On the other hand, the price increase has several unintended consequences, some of which tend to close the gap.

1. Keynes’ Effect: The interest rate will increase when the money supply is stable or increases more slowly than prices tend to lower the investment cost.
2. Wealth Effect: Higher prices may reduce consumer spending by diminishing real wealth from government money and debt.
3. Balance-of-Trade Effect: When there is an increase in cost, imports will be favored as people will now buy cheap foreign goods, and exports will decline as we start exporting our goods at a higher price.
4. Fiscal Effect
   • If tax revenues increase more quickly than prices, this will cause a downward shift in consumption by lowering real disposable income.
   • Transfer payments fixed in money terms lose some significance when expressed realistically, lowering consumption spending.
   • If budgets are set in monetary terms, there will be a decrease in actual government purchases. 
5. Price Expectation Effect: If the current price increase is anticipated to be brief and followed by a subsequent price decline, durable consumer purchases and investments in machinery and equipment may be put off, and inventories may be reduced, which would help close the i-gap.
6. Redistribution Effect: A fixed wage rate or a wage adjustment gap means that any price increase will only increase profits. A transfer of income toward profits will reduce aggregate demand and the i-gap, assuming that the marginal propensity to consume of the profit earners is lower than the wage earners.
7. Money Illusion Effect: Inflation will lower the real worth of such spending and bridge the i-gap if some spenders have money illusions and at least some of their spending is fixed in money terms. Fiscal policy could cut government spending and raise taxes, reducing overall economic spending instead of waiting for natural processes to narrow the i-gap.
   • In other words, there should be a budget surplus for the government. In addition, the use of monetary policy can reduce the money supply. 
   • However, Keynesians question the effectiveness of monetary policy in addressing inflationary and deflationary circumstances.

Inflationary gap and inflation Rate

The percent change in the market prices of the basket of chosen commodities and services over a given time is known as the inflation rate.

The index of consumer prices has increased due to the rising inflation rate, which shows that the currency's value has decreased (CPI). In other words, when the value of a currency decreases, the rate at which the prices of products rise is defined as the inflation rate.

The expansion of the money supply is one of the most frequent reasons for inflation in a country's economy.

The government and central banks closely monitor the inflation rate as a gauge of an economy's health and enable them to adjust their monetary policies as necessary.

The following equation shows how to determine the inflation rate:

Inflation rate = (Current period CPI − Prior period CPI)/Prior period CPI

The inflation rate (or the pace at which prices grow) and the i-gap have a positive functional connection; the bigger the gap, the faster the prices will go up; the smaller the disparity, the slower the prices rise.

Thus, we draw the following conclusions: 

• The size of the i-gap directly affects the inflation rate. 
• When the i-gap is zero, the rate of price increase is one, or there is a zero percent increase in prices every period.

inflation Vs. Deflation Gap

When the output is at full employment and aggregate demand (AD) is greater than aggregate supply (AS), there is an i-gap. 

In this scenario, money income increases to a higher equilibrium while real income (at the level of full employment output) stays constant. 

Prices increase due to consumers bidding up prices to compete for a small output.

In other words, the i-gap represents that real income cannot increase at full employment levels of output while prices rise to the point where AD > AS. 

The i-gap persists until either AS is increased through economic growth or AD decreases to a level consistent with full employment.

A deflationary gap exists when output is at full employment and aggregate demand (AD) is lower than aggregate supply (AS). In this situation, income equilibrium occurs even when some resources are idle. 

In other words, the deflationary gap illustrates the unemployment scenario brought on by the output level associated with full employment, AD-AS.

The deflationary gap, and the following conditions of unemployment and slow economic activity, will endure until a higher aggregate demand consistent with full employment is attained. 

The deflationary gap is therefore measured as the difference between AD and AS at full employment.

Gaps in inflation and deflation

The phrases "inflation" and "deflation" are frequently used in macroeconomics. Almost every nation on earth is affected by these two events. Therefore, inflation and deflation are viewed as two sides of the same coin.

When the cost of goods and services rises, the economy's purchasing power declines or the purchasing power of the money itself declines; this is referred to as inflation.

1. There is always a consistent or continuous increase in the cost of products and services, which is not seasonal and has the propensity to last for a lengthy period.
2. The majority of the economic sectors are affected.

The complete opposite of inflation is deflation. In this circumstance, the cost of products and services falls precipitously, increasing the purchasing power of money.

In other words, when an economy experiences deflation, people can buy more goods with the same amount of money.

Researched and authored by Parth Singhal | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

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• Maastricht Treaty
• Macroeconomics
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• Marginal Propensity to Consume