Inflationary Gap - Causes, Effects and Solutions

Causes, Effects and Solutions

The main cause of the gap is considered to expansionary monetary policies carried out by the government. An inflationary gap is a signal that the economy is in the boom part of the trade cycle, resources are being used over their capacity, factories are operating with increasing average costs; wage rates increase because labour is used beyond normal hours at overtime pay rates. A case of the gap can arise when consumer or investor spending is very buoyant, when foreign demand is increasing or when government expenditure increases. According to some economists, such a situation arose in the United States in 1999-2000 and 2006-2007, when the unemployment rate was below 5%. Wages increase as a result of the increase in aggregate demand which in turn raises business costs. This leads to an increase in prices (inflation) and these higher prices reduce consumer purchasing power, causing aggregate demand to fall and the output gap to close. When the gap is finally eliminated, equilibrium is achieved, with actual GDP equal to potential GDP but at a higher price level. Economists warn that this is not an auto mechanism. Government action in the form of fiscal and monetary policies is a must to close the gap. Monetary policy can be used to contract the money supply in the economy by raising interest rates, which would reduce purchasing power, resulting in falling demand. Keynes, however, was not in favour of monetary methods. He suggested a method of progressive taxation, where the collections from the taxes would be saved and used once equilibrium is achieved in the economy, which he called 'forced savings' Another method is to cut transfer payments and subsidies, thus cutting down consumption.