Question

What is meant by inflationary gap?

Explain the concept of inflationary gap.

Explain briefly the concept of inflationary gap. Use diagram.

Explain the concept of inflationary gap with the help of a suitable diagram.

Explain the concept of inflationary gap with the help of a diagram. What is its impact on output?

Answer 1

Excess demand occurs in a situation when aggregate demand is more than aggregate supply corresponding to full employment. It leads to the reduction in inventories and inflation in the economy. This situation is considered an inflationary gap the difference between aggregate demand beyond full employment and aggregate demand at full employment.

Aggregate demand is the AD curve, and aggregate supply is the AS curve (as shown in the diagram below). While the aggregate demand curve and the aggregate supply curve intersect each other, the full employment equilibrium is attained at Point E. OY is the full employment level of output, and EY is the aggregate demand at full employment level of output. If the aggregate demand increases beyond the full employment level of output from EY to FY, then the economy will have excess demand, i.e., a situation of an inflationary gap (FY − EY = FE).

Answer 2

To put it another way, excess demand occurs when actual aggregate demand in an economy exceeds aggregate supply at full employment. When the economy is at full employment, excess demand cannot be eliminated because existing resources are already completely utilized. This additional demand will drive up the price level. A high level of aggregate spending relative to full employment output will result in shortages of items in the economy, driving up prices and causing inflation. Thus, extra demand has no effect on the quantity of output or employment in the economy but does cause inflation. This is why excess demand (or gap) is referred to as the “inflationary gap.” Inflationary gap refers to the amount by which actual aggregate demand exceeds aggregate supply at full employment. Thus, the inflationary gap represents the amount of surplus demand in the economy.