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An inflationary gap occurs when a nation’s real GDP exceeds its potential GDP, leading to rising prices and inflation. This can be caused by increased demand or rising production costs. Governments can control demand by raising taxes or interest rates, while supply-side advocates suggest reducing regulations and taxes. Higher taxes can also lead to decreased productivity and rising prices.
An inflationary gap is an output gap in which a nation’s real inflation-adjusted gross domestic product (GDP) exceeds its full-fledged potential GDP. When an inflation gap occurs, it indicates that the growth in demand for products and services outpaces the growth in the ability to supply those goods and services. Economists consider an inflation gap to be a harbinger of inflation. Both increased demand and rising occupancy levels, in response to demand, will cause prices to rise over time. Factors pushing real GDP up include increases in investment, exports, consumer spending, or government spending.
Potential GDP at full employment reflects the monetary value of all the goods and services the nation can produce within a given year if all are employed. This value is adjusted for inflation from a base year to account for price changes. If real GDP falls below full employment, potential GDP, a recessionary gap occurs, which is the opposite of an inflationary gap. A recessionary gap indicates that demand growth is not keeping pace with supply growth, leading to rising unemployment levels. High unemployment reduces consumer spending and decreased demand leads to falling price levels, called deflation.
There are two accepted theories regarding the causes of inflationary gaps. In growing economies with rising employment, rising consumer spending floods the market with excess liquidity for a finite number of goods. This is called “pull-demand” inflation. On the other hand, as production costs rise, companies have to charge higher prices to maintain their profit margins. This is called cut-cost inflation.
Inflation, especially if it is unanticipated, has serious negative consequences for some people. People living on fixed incomes are particularly hard hit, because every dollar they spend buys fewer goods, ultimately to the detriment of their standard of living. Inflation hurts creditors and helps debtors, with the result that banks are unwilling to lend. Loan repayments do not take into account inflation, which is essentially interest-free principal. Investment and consumer spending tend to slow down due to market uncertainty, which slows down the economy. Additionally, inflation can make domestic products less competitive in a global marketplace.
In order to minimize the size of an inflation gap after a period of booming activity, governments can change monetary policy to control demand by raising taxes or raising interest rates, both of which reduce consumer spending. Alternatively, the government can drastically reduce its expenditures. Supply-side advocates advocate measures to increase productivity and increase supply by reducing government regulations and capital gains taxes. Furthermore, they demand reductions in the marginal tax rate.
An inflationary gap can occur when tax rates negatively affect the economy’s output. Higher taxes reduce the incentive for people to work and invest. When taxes rise, workers can take more vacations, retire earlier, or give up their jobs altogether. Some workers may leave the country to keep a higher percentage of what they earn. As fewer workers are available in the workplace, wages rise, increasing production costs. The result is a rise in prices and a decrease in productivity.
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