Question

- An increase in AD causes what type of gap?

- An inflationary (or expansionary) gap causes what effect?

Answer 1

The inflationary gap arises, when actual output is greater than the potential output. So for closing the gap, government uses Contactionary fiscal policy.

For fighting with the inflation rate, government uses contractionary fiscal policy.

Under Contractionary fiscal policy, therefore government either decreases the government spending or increase tax. So aggregate demand decreases, so AD curve shifts leftward, so price decrease and output also decrease. Hence inflation rate also decreases.

1.

As it can be seen in the diagram that economy is initially long-run or full employment level at the intersection of AD, SRAS and LRAS curve at point 1.But when AD increases from AD to AD1, then new short-run equilibrium is at point 2 at the intersection of AD1, SRAS curve. Since short-run equilibrium level of output is greater than the potential level of output. So this gap is inflationary gap. The inflationary gap is the difference between Yp and Y1.

2.

An inflationary gap leads to deviation from potential level of real GDP. This causes an inflation in the economy. Hence price level in the economy increases due to inflationary gap.