Inflationary Gap
Candlefocus EditorWhen the GDP is operating below its full potential, the level of production and employment is lower than the level necessary to maintain price stability. A bad output situation in an economy can lead to rising prices. This is caused by an increase in the demand of goods and services but with a lack of available supplies, which then leads to an increase in prices.
Inflationary gaps generally occur because of low government spending, low aggregate demand, and higher interest rates. When the government does not spend enough money on public services, jobs, and unemployment, the aggregate demand does not meet the levels needed to sustain full employment. At the same time, high interest rates discourage borrowing and dampen consumer buying power.
To reduce an inflationary gap, governments may need to implement policy changes. These policy changes include reducing taxes, increasing government spending, issuing bond and securities, and raising interest rates. Raising taxes will bring in more revenue to fund government projects and discourage consumer spending. In contrast, reducing taxes and increasing government spending will put more money into the pockets of consumers and encourage consumer spending.
Issuing bond and securities in capital markets also helps to reduce inflationary gaps as it increases the supply of money. Finally, raising and lowering the interest rates can affect business investments, consumer spending and government spending. All of these changes will help create the necessary aggregate demand needed to reach the potential GDP.
Inflationary gaps can have severe economic impacts. When GDP is operating at a lower level, it affects the business cycle, unemployment, price stability and the overall quality of life. Policymakers should take note of the signs of an inflationary gap so that corrective measures can be taken as soon as possible.