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Definition:  An inflationary gap, also known as an expansionary gap, is the difference between the real GDP and the full-employment real GDP. In fact, the real GDP outweighs the full employment real GDP because an increase in the real GDP causes the general price level to rise in the long-term.

What Does Inflationary Gap Mean?

What is the definition of inflationary gap?  An inflationary gap is always related to a business-cycle expansion and arises when the  equilibrium level  of an economy’s aggregate output is greater than the output that could be produced at full employment.

For instance, the economy’s total output is $6 trillion and the full-employment real GDP is $4 trillion, the inflationary gap is $2 trillion, which means that the aggregate output has to decrease by $2 trillion to eliminate the inflationary gap. To fight this gap, governments impose a  contractionary fiscal policy  that increases taxation and decreases government spending to lower disposable income and consumption, thus lowering the aggregate  demand  and the general price level.

Let’s look at an example.

Example

Saudi Arabia employs all its available resources and produces 11.6 barrels of oil per day. The aggregate demand for oil is estimated at 5 barrels of oil per day because there is a growing uncertainty over oil supplies, regional conflict and price hikes, which lower consumer confidence. In this case, since the aggregate demand ( real GDP ) is lower than the full-employment real GDP, there is no inflationary gap.

Conversely, if the aggregate demand for oil was 13.2 barrels of day, and consumer confidence was high, there would be an inflationary gap of 1.6 barrels of oil per day because the aggregate demand (real GDP) would be higher than the full-employment real GDP.

Therefore, when the full-employment real GDP is X, and the aggregate demand (real GDP) is X+1, there is an inflationary gap that needs to be corrected with  contractionary fiscal policy .

Summary Definition

Define Inflationary Gap:  The inflationary expenditure gap is an economic term that describes the difference between what an economy can produce at full employment and what the real GPD is.


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