How Fiscal Policy control Inflation

In the situation of inflation there is a high price rise in the economy, this is due to increase in Aggregate Demand (AD). When there is an increase in AD beyond the full employment level, output remain constant since output cannot be increased as there is full employment, all resources are fully utilized, this leads to an increase the cost of production of existing factors of production and price rises. More and more rise in prices leads to a situation of inflation due to the situation of excess demand .

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