Inflationary Gap - The Mechanism

The Mechanism

Let the full employment output be Y_F and the actual output that the economy is currently producing be Y. If the difference Y_F - Y is negative, the actual national income exceeds the potential national income, which is known as the inflationary gap. If this gap is positive, it is known as recessionary gap.

The inflationary gap is always an ex-ante phenomenon, it is always expected to occur in the future. It arises when expected expenditure will not equal expected consumption at a future date.

Keynes defines it as the excess demand in the market for consumption of goods and services. He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices.Given a constant average propensity to save, rising: money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main determinants that cause an inflationary rise of prices.

When an initial increase in aggregate demand produces inflation (so called demand-pull inflation) and real GDP increase, the price level and real GDP are determined at the point where the new aggregate demand and the short-run aggregate supply meet. This point is known as above full-employment equilibrium, since the short-run aggregate supply is above the long-term aggregate supply, i.e. above the aggregate supply at full employment. The gap created between real GDP and potential GDP is the consequence of inflation, this is one of the reasons this type of gap is called an inflationary gap.

Obviously, this situation cannot last forever, because there is a shortage of labour. The shortage of labour produces the rise of wage rates, which makes the short-run aggregate supply decrease, until it reaches the full-employment level. The short-run aggregate supply decrease makes an upward pressure on the price level, consequently causing inflation. The once created gap between real GDP and potential GDP was the sign of forthcoming inflation, this is another reason this type gap is called an inflationary gap.