Inflationary gap
Potential (light) and actual (bold) GDP estimates from
the Congressional Budget Office.
An inflationary gap, in economics, is the
amount by which the actual gross
domestic product exceeds potential full-
employment GDP.[1] It is one type of output
gap, the other being a recessionary gap.
Overview
The concept of the inflationary gap was
first given by John Maynard Keynes in his
work How to Pay for War? (1940) this
method was basically employed to study
and solve problems regarding war finance.
Keynes starts the analysis of the
inflationary gap from the level of full
employment equilibrium whereas his other
analyses are based on under-employment
equilibrium.
Mechanism
Let the full employment output be YF and
the actual output that the economy is
currently producing be Y. If the difference
YF - Y is negative, the actual national
income exceeds the potential national
income, which is known as the inflationary
gap.[2] 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.[3]
Keynes defines it as the excess demand in
the market for consumption of goods and
services.[4] 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,[1] 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.
Causes, effects, and solutions
The main cause of the gap is considered
to be 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, and wage rates
increase because labour is used beyond
normal hours at overtime pay rates.[2] 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%.[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 automatic 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'[6] Another
method is to cut transfer payments and
subsidies, thus cutting down
consumption.
Criticism
Milton Friedman criticized the Keynesian
inflationary gap on the grounds that gap
analysis can be used only under special
circumstances like wartime. He stated
that the analysis did not improve our
knowledge of business cycles to a great
extent[3]. Bent Hansen criticized Keynes
for limiting his analysis of the gap only to
the goods market, leaving out the factor
market. According to him, the gap is
caused due to excess demand in both the
goods and factor market. Another
drawback of this model is its static nature,
which was criticized by Milton Friedman,
Erik Lundberg[7] and other economists.
Keynes himself recognised this drawback
and introduced time lags concerning
receipts and expenditure of income. T.
Koopmans introduced the idea of the
speed of inflation, stating that the
inflationary gap reduces as the speed of
inflation falls.[8] Another weakness of the
theory is that it is concerned only with flow
concepts like current income, expenditure,
consumption, and saving. However the
increase of prices affects not only current
goods but also the stock of goods already
out in the market. This point is ignored in
the theory.
Despite these criticisms, the concept of
inflationary gap has proved to be of much
importance in explaining rising prices at
full employment level and policy measures
in controlling inflation.
See also
Recessionary gap
Inflation
References
1. Parking, Michael (2007). "Economics,
Level I CFA Program Curriculum". 2:
307–308.
2. Lipsey, Richard G. (1992). An
introduction to positive economics
(7th ed.). London: ELBS with
Weidenfeld and Nicolson. p. 573.
ISBN 0-297-79556-2.
3. Freidman, Milton (June 1942).
"Discussion on the Inflationary Gap".
The American Economic Review.
No.32, Part 1: 314–319.
4. Frisch, Helmut (1983). Theories of
Inflation . Cambridge University Press.
pp. 229–234. ISBN 9780521295123.
5. Blinder, William J. Baumol, Alan S.
Macroeconomics : principles and
policy (11th ed., 2010 update ed.).
Australia: South-Western, Cengage
Learning. ISBN 1-4390-3901-1.
6. Tcherneva, Pavlina R. "Keynes’s
Approach to Full Employment:
Aggregate or Targeted Demand?" ,
Levy Economics Institute, Bard
College, August 2008
7. Jonung, edited by Lars (1993).
Swedish Economic Thought :
Explorations and Advances. London:
Routledge. ISBN 0-415-05413-3.
8. Koopmans, T. (May 1942). "The
Dynamics of Inflation". The Review of
Economics and Statistics. 24 (2).
doi:10.2307/1924376 .
External links
[1] psnacet.edu.in
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