Inflationary gap

Inflationary gap is the excess of Aggregate Demand over and above its level required to maintain full employment equilibrium in the economy.

When there is a situation of excess demand, the level of output does not rise since factors are already fully employed.

Output level remains constant corresponding to full employment. A high level of aggregate spending relative to full employment level of output will generate shortages of goods in the economy, which would push up prices and causes inflation.

A situation of inflationary pressure emerges in the economy.

Inflationary pressure is proportionate to excess demand i.e. inflationary gap is a measure of the amount of excess demand in the economy.

Greater the excess demand, greater the inflationary pressure.

Below graph explains the inflationary gap

Inflationary gap

AD: Aggregate demand at full employment

AD₁: Aggregate demand beyond full employment

AB: Excess demand = inflationary gap

OM: Full employment level of output

AD is Full employment Aggregate Demand. The intersection of AD  curve with 45^◦ line at B gives us the equilibrium corresponding to full employment level of output M.

Now, suppose aggregate demand curve shifts upwards to AD₁ due to say, increase in government expenditure.

The output will not rise since the economy is at full employment level of output. It will only cause a pressure of demand on the existing output which will leads to rise in prices. The economy faces a situation of inflation.

Situation of excess demand is described as a situation of inflationary gap in the economy.

Inflationary gap = AD beyond full employment – AD at full employment = AB

Inflationary gap = AD₁  -  AD = AB