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

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 .

What is macroeconomics? State its vital components

Answer :

Macroeconomics refers to the study of economic problem or economic issues at the level of an economy as a whole. In this the focus shifts from maximization of individuals gain (as in microeconomics) to maximization of social welfare. The central issues in this relate to the overall level of employment, growth rate of national output, the general price level, and stability of the economy.

The vital components of Macroeconomics are:

1. Theory related to Equilibrium level of output and Employment : It studies how equilibrium is struck when Aggregate supply (AS) = Aggregate Demand (AD).

2. Theory related to Inflationary and Deflationary Gap in the economy : It studies how departure from full employment equilibrium output causes inflationary or deflationary gap.

3. Theory of Multiplier : It analysis the process of income generation by investment expenditure in the economy.

4. Money supply and Credit Creations : It studies the components of money supply and role commercial banks in money supply through credit creation.

5. Fiscal and Monetary Policies : Budgetary and monetary measures to correct the situations of inflationary and deflationary gap.

6. Government Budget : It focuses on the measurement and impact of budgetary deficits in the economy.

7. Exchange rate and BOP : It analyses how exchange rate is determined in the international money market and how BOP impacts the level of economic activity in the domestic economy.

What is the Difference between Microeconomics and Macroeconomics

to know about this read - Difference between Microeconomics and Macroeconomics

How Fiscal Policy provides Stability, growth and Equity

The objectives of Fiscal policy in developed country is different from those in underdeveloped countries. The main objective of fiscal policy in developed countries is maintaining economic stability. Economic development is the main objective in underdeveloped countries.

The main objectives of fiscal policy are as follows:

1) Stability

2) Growth

3) Equity

Economic Stability

Providing stability to the process of growth and development is the key role of fiscal policy in any economy.

Economy stability means that the level of economic activity is maintained at a stable level so that there are no fluctuations in output and employment.