What Is an Inflationary Gap?

What Is an Inflationary Gap?

An inflationary gap measures the difference between the current level of real gross domestic product (GDP) and the GDP that would exist if an economy was operating at full employment.

Understanding an Inflationary Gap

An inflationary gap exists when the demand for goods and services exceeds production due to higher levels of employment, increased trade activities, or elevated government expenditure. The real GDP can exceed the potential GDP, resulting in an inflationary gap:

$\begin{aligned}&\text{Inflationary Gap} = \text{Actual GDP} - \text{Anticipated GDP} \\\end{aligned}$​Inflationary Gap=Actual GDP−Anticipated GDP​

The inflationary gap represents the point in the business cycle when the economy expands as consumers purchase more goods and services. As demand increases but production lags, prices rise to restore market equilibrium.

The real GDP must be higher than the potential GDP for the gap to be considered inflationary. When the potential GDP is higher than the real GDP, the gap is instead referred to as a deflationary gap.

Calculating Real Gross Domestic Product (GDP)

GDP measures the monetary value of final goods and services produced in a given period and bought by the final user within an economy. GDP is composed of goods and services for sale in the market and includes some nonmarket output, such as defense or education services provided by the government. 

According to macroeconomic theory, the goods market determines the real GDP, shown in the following relationship. To calculate real GDP, first compute the nominal GDP:

$\begin{aligned}&\text{Y} = \text{C} + \text{I} + \text{G} + \text{NX} \\&\textbf{where:} \\&\text{Y} = \text{Nominal GDP} \\&\text{C} = \text{Consumption expenditure} \\&\text{I} = \text{Investment} \\&\text{G} = \text{Government expenditure} \\&\text{NX} = \text{Net exports} \\\end{aligned}$​Y=C+I+G+NXwhere:Y=Nominal GDPC=Consumption expenditureI=InvestmentG=Government expenditureNX=Net exports​

Then, the real GDP = Y/D, where D is the GDP deflator, which takes inflation into effect over time.

An increase in consumption expenditure, investments, government expenditure, or net exports causes real GDP to rise in the short run. Real GDP provides a measure of economic growth while compensating for the effects of inflation or deflation. This accounts for the difference between actual economic growth and a simple shift in the prices of goods or services within the economy.

Fiscal and Monetary Policy to Manage the Inflationary Gap

A government may use fiscal policy to help reduce an inflationary gap by decreasing the number of funds circulating in the economy. This is accomplished through reductions in government spending, tax increases, bond and securities issues, and transfer payment reductions.

These adjustments to the fiscal conditions within the economy can restore economic equilibrium. As the amount of money in circulation decreases, the overall demand for goods and services declines, reducing inflation.

Central banks also have tools at their disposal to combat inflationary activity. When the Federal Reserve (Fed) raises interest rates, borrowing funds is more expensive.

Tight monetary policy can lower the money available to most consumers, triggering less demand and inflation retreats. Once equilibrium is reached, the Fed or other central bank can shift interest rates accordingly.

The Bottom Line

An inflationary gap measures the difference between the current real GDP and the potential GDP where an economy operates at full employment. The current real GDP is higher than the potential GDP for the gap to be inflationary. Governments impose policies to reduce an inflationary gap, such as reductions in government spending and tax and interest rate increases.