An inflationary gapin economicsis the amount by which the actual gross domestic product exceeds potential full-employment GDP. The concept of the inflationary gap was first given by John Maynard Keynes in his work How to Pay for War? 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.

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.

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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. Given a constant average propensity to save, rising: 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. 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 invest bse stock market watch software download level, consequently causing inflation. The once created gap between real GDP and potential GDP was the sign 5 min best strategy for binary options trading forthcoming inflation, this is another reason this type gap is called an inflationary gap.

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 cycleresources are being used over their capacity, factories are operating with increasing average costs; wage rates increase because labour is used beyond normal hours at overtime pay rates. 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 auto mechanism. Government action in the form of fiscal and monetary how to make money in an inflationary economy is a must to close aud usd exchange rate commonwealth bank gap.

Monetary policy can be used to contract the money supply dow jones industrial average components market cap 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.

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. 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 FriedmanEric Lundberg [7] and other economists. Keynes himself recognised this drawback and introduced time lags concerning receipts and expenditure of income. Koopmans introduced the idea of the speed of inflation, stating that the inflationary gap reduces as the speed of inflation falls. However the increase of prices affects not only current goods but also the stock of goods already out in the market.

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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.

From Wikipedia, the free encyclopedia. An introduction to positive economics 7th ed. ELBS with Weidenfeld and Nicolson. The American Economic Review.

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