Inflationary Gap

Definition:

The inflationary gap is the difference between the rate of inflation (the rate of increase in prices) and the rate of economic growth.

Explanation:

• Positive inflationary gap: When inflation is higher than economic growth, it is said to have a positive inflationary gap.
• Negative inflationary gap: When inflation is lower than economic growth, it is said to have a negative inflationary gap.

Causes:

• Demand-pull inflation: Occurs when there is an increase in aggregate demand, leading to higher prices.
• Cost-push inflation: Occurs when the cost of production increases, such as raw materials or labor costs.
• Built-in inflation: Occurs when inflation expectations are high, even when there is no underlying economic growth.

Impact:

• Erodes purchasing power: Inflation erodes the purchasing power of money, meaning that it can cost more to buy the same goods and services over time.
• Raises interest rates: Central banks may raise interest rates to curb inflation.
• Slows economic growth: High inflation can slow economic growth by making it more difficult for businesses to borrow money and invest.
• Increased inequality: Inflation can exacerbate income inequality, as poorer households tend to spend a larger portion of their income on necessities that are rising in price.

Examples:

• When inflation is 5% and economic growth is 3%, there is a negative inflationary gap of 2%.
• When inflation is 8% and economic growth is 5%, there is a positive inflationary gap of 2%.

Note:

The inflationary gap is an important concept in macroeconomics. It is a key factor in determining the overall health of an economy.