An inflationary gap results from an overcapacity economy. When unemployment is below its natural rate, GDP output is lower than expected. Consider a GDP spike caused by rising inflation.

Also known as an expansionary gap, here's a simple example. In an economy operating at full employment without inflation, people demand 500,000 sweaters annually. Then inflation strikes, leading to higher wages and, consequently, more income. As a result, they now want 550,000 sweaters. This demand increase of 50,000 sweaters is what we refer to as an inflationary gap.

The growth in demand translates into additional revenue and higher costs for materials for sweater manufacturers, assuming they can capitalize on this demand profitably. If they fail to meet this demand, the gap symbolizes potential lost sales.

How the Inflationary Gap Functions

The inflationary gap comes into play when inflation causes wages to rise, boosting consumer demand. This gap is rooted in two economic principles: the non-accelerating inflation rate of employment (NAIRU), or the short-term natural rate of unemployment, and the concept of potential GDP. These estimates represent the economy's output if labor and capital were fully utilized. A Phillips curve balances inflation and employment, according to economists.

The natural unemployment rate accommodates routine events like new graduates joining the workforce, job losses due to poor performance, or business failures from lousy management. When labor demand increases, employers increase wages to attract employees, potentially pushing employment above the natural rate. This can lead to a quicker inflation rate. Evaluating the inflationary gap helps understand these inflation effects.

However, these ideas often spark debates among economists, especially regarding the actual level of natural unemployment and the concept of potential GDP. If determining a precise natural unemployment rate is challenging, then calculating an inflationary gap becomes equally tricky.

Economic novices can understand that inflation occurs when employers raise wages to attract workers. Wage increases boost workers' spending power, driving demand for goods and services.

Formula for Inflating Gap

An inflationary gap occurs when a nation's GDP exceeds its potential GDP. This suggests the economy is overcapacity. Calculate this gap using the formula:

Inflationary Gap = Actual GDP – Potential GDP.

If GDP was supposed to have been $5.5 trillion rather than $6 trillion, then the inflationary gap amounts to $0.5 trillion. This number shows that the world’s economy does produce more products than need it.

Calculating Real GDP Made Simple

Basic Formula for Nominal GDP

GDP represents the total monetary value of goods and services produced and consumed within a nation's borders in a specific period. It includes market and nonmarket outputs like government services. The formula for calculating nominal GDP (Y):

Y = + Investment (I) + Consumption (C) + Government Expenditure (G) + Net Exports (NX)

Take, for example, when consumptions amount to $2 trillion, investments are $1 trillion, and expenditures from the government are $1.5 trillion, then there will be net exports of goods and services that total $0.5 trillion, leading to a nominal GDP of

Transitioning to Real GDP

Real GDP, which accounts for inflation, better measures economic growth. It is calculated by dividing nominal GDP (Y) by GDP deflator. By removing inflation and deflation, this adjustment clarifies economic growth.

If nominal GDP is $5 trillion and GDP deflator is 1.2, real GDP is $4.17 trillion. This number is crucial because it excludes price level changes and shows economic growth.

What Leads to Inflationary Gaps?

Inflationary gaps can arise from various sources. The first is that government spending can increase demand faster than supply. It is when there is higher government spending that the prices, in turn, go up.

Central banks may revitalize the economy by reducing interest rates or increasing money supply. Although these policies are well-intentioned, they can create an inflationary gap if the economy cannot fulfill society's demands.

Finally, economic confidence boosts business and consumer spending and investment. Financial activity can increase demand, causing inflation. These three factors - government spending, monetary policy, and confidence levels - are vital in understanding how recessionary and inflationary gaps occur.

Managing Inflationary Gaps with Fiscal and Monetary Policy

To tackle an inflationary gap, the government employs fiscal policy tools. This involves cutting down the amount of money circulating in the economy.

The government achieves this by reducing spending, increasing taxes, selling bonds and securities, and decreasing transfer payments. This approach aims to balance the economy by reducing overall demand for goods and services, which in turn helps lower inflation levels.

Central banks must control recessionary and inflationary gaps. For instance, the Fed raises interest rates, making borrowing more expensive. Higher borrowing costs reduce consumer and business money, lowering demand and inflation. Central banks like the Fed adjust interest rates to maintain economic balance.

Effects of a Gap in Inflation

Price Increases Due to Inflationary Gap

Price increases during recessionary and inflationary gaps. Prices are raised when the goods and services supply is insufficient to meet demand.

Price increases reduce people's buying power, limiting their spending. The inflationary gap reduced real income. Due to rising inflation, your purchasing power is declining.

Wages and Inflation

Inflationary gaps can start a cycle where wages and prices keep climbing. Here's how it works: as prices rise due to inflationary gaps, people's living costs increase. To keep up with these costs, workers ask for higher wages.

But, when wages increase, businesses often raise prices to cover these higher labor costs. This cycle of rising wages and prices can worsen inflationary gaps and hurt an economy's ability to compete globally.

Market Imbalances from Inflationary Gaps

When an economy faces an inflationary gap, it can mess up how resources are used. This gap creates too much demand that businesses struggle to meet. This struggle can lead to shortages, delays, and sometimes poorer quality products.

These market distortions are a significant downside of inflationary gaps. They show how inflationary gaps can lead to inefficient resource use and upset the normal functioning of markets.