Inflationary Gap
What is the Inflationary Gap?
Imagine a small bakery that can only bake 100 loaves of bread per day. If 120 people want to buy bread, there aren’t enough loaves. In an entire country, this happens when people, businesses, and the government want to buy more than factories can produce. This difference—the amount of extra demand—is the inflationary gap. Because there aren’t enough goods, sellers raise prices, and inflation begins.
Economists measure it by comparing the actual output (what is being bought) to the potential output (what could be produced if everyone who wants a job has one). The gap is the amount by which actual demand exceeds the economy’s maximum sustainable production.
What Causes Excess Demand?
Several factors can create too much demand:
- High consumer confidence – When people feel optimistic, they spend more, boosting demand.
- Government spending – Large public projects or tax cuts leave more money in people’s pockets.
- Export boom – If other countries buy a lot of local products, demand rises.
- Easy credit – Low interest rates encourage borrowing and spending.
| Situation | Demand vs. Supply | Effect on Prices |
|---|---|---|
| Healthy economy | Demand ≈ Supply | Stable prices |
| Inflationary gap | Demand > Supply | Prices rise (inflation) |
Real-World Example: The Gaming Console Rush
When a new, highly anticipated video game console launches, stores might have only 10,000 units, but 15,000 people want to buy one. Because of the shortage, some people offer to pay more than the official price, and resellers list them at higher prices online. This mini inflationary gap shows the same forces at work in the whole economy. If a country’s total demand for cars, houses, and food outruns its factories, the general price level rises—just like the price of the console.
Inflationary Gap = Actual GDP – Potential GDP
(where Actual GDP > Potential GDP)
Closing the Gap: Cooling Down Demand
Governments and central banks try to reduce the inflationary gap by making spending less attractive. They might:
- Raise interest rates – Borrowing becomes expensive, so people and businesses spend less.
- Increase taxes – When people pay more taxes, they have less money to spend.
- Cut government spending – The government itself buys fewer goods and services.
These actions reduce aggregate demand, bringing it back in line with productive capacity and stabilizing prices.
Important Questions
An inflationary gap happens when demand is too high and prices rise. A recessionary gap (or contractionary gap) occurs when demand is too low, leading to unemployment and falling prices. They are opposites.
No. If demand stays above capacity, prices will keep rising. Eventually, higher prices reduce purchasing power, or the central bank steps in to cool the economy. The gap usually triggers actions that bring it back to balance.
Economists estimate potential GDP (what the economy can produce at full employment) and compare it to actual GDP. If actual GDP is larger, the difference is the inflationary gap.
Footnote
[1] Aggregate demand (AD): Total spending in an economy—by households, businesses, government, and foreign buyers.
[2] Productive capacity / Potential GDP: The maximum output an economy can produce without causing inflation, when all resources (labor, machines) are fully used.
[3] Demand-pull inflation: Inflation that starts because total demand is growing faster than total supply.