Question

Demonstrate graphically and explain verbally the case of an inflationary gap. Describe the forces in the economy that will result in the gap closing itself.

Answer 1

An inflationary gap is a macroeconomic concept that describes the difference between the current level of real GDP and the anticipated GDP that would be experienced if an economy is at full employment. For the gap to be considered inflationary, the current real GDP must be the higher of the two metrics.

The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The inflationary gap is so named because the relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run.

The diagrammatical representation of the Inflationary gap is as follows:

Also, Inflationary gap can be eliminated/ minimized by using monetary policy and or fiscal policy instruments. Under the monetary policy, money supply is reduced and/or interest rates are increased. This gap, however, can be reduced either by reducing money income through reduction in government expenditure, or by increasing output of goods and services, or by increasing taxes.