Understanding Inflationary gap in an Economy

In macroeconomic level, when there is excess of aggregate demand over aggregate supply at a situation of full employment, the gap of difference is called the inflationary gap. The terms might be confusing and thus are explained below.

Aggregate demand is the total demand of all final goods and services produced in an economy. It can also be said defined as the total quantity of money that all sectors of an economy are willing to spend on the purchase of goods and services at a given period. Aggregate demand consists of expenditures relates to consumption, investment by firms, purchase of goods and services by the government and finally the net exports( difference of imports from exports). The aggregate demand curve does not start from origin because it cannot begin from value zero. It is because even at zero level of income, there is some level of consumption, known as autonomous consumption. Just because we do not receive income doesn’t mean we don’t eat. We borrow money and still have some consumption level. Thus there is still expenditure on consumption and aggregate demand curve can never start from origin(0,0).

Aggregate supply is the money value of the total output available in the economy for purchase during a given period. Aggregate supply also represents the national income of a country.

Full employment is a situation where all those able bodied persons who are willing to work at the existing wage rate, are actually employed( meaning no unemployment in an economy).

As we move on to inflation. How does it actually occur?

In layman terms, when there is increased demand for a good or service than the supply, it leads to an increase in the price of the commodity or service as consumers are willing to pay more to obtain it. Thus the increasing prices lead to inflation.

The concept of inflationary gap is explained with a graph:

Aggregate demand curve is synonymous to total or aggregate expenditure or price and is thus taken on the Y-axis. Aggregate supply curve is synonymous to total income or total output which taken in the X-axis.

At the level of full employment, the aggregate supply is a 45 degree line. The aggregate demand curve is represented as AD0. Both these curves intersect at point A which is said to be an equilibrium point.

An equilibrium point in layman terms it is the point at which the the market forces balance or equate. It is a state of rest. It literally means :

Aggregate demand = Aggregate supply, at a given price and quantity.

A note to the reader, the price and quantity at the point of equilibrium is the equilibrium price and equilibrium quantity respectively.

In case of inflation, aggregate demand>aggregate supply.

As I said above, price and aggregate demand are synonyms. When is an increase in price, it implies an increase in aggregate demand. So, excess of aggregate demand pushes the curve upwards. So there is a shift in the position of the demand curve. The demand curve shifts from AD0 TO AD1. We arrive at the new demand curve. The new equilibrium point is at E.

So Aggregate demand = Aggregate supply at the equilibrium point E where the new equilibrium price and quantity are higher than the old ones.

In the graph we can clearly see gap maintained between the two demand curves and the gap is constant throughout. The inflationary gap thus lies between the new and old aggregate demand curves.

Relevant links: https://www.intelligenteconomist.com/inflationary-gap/ https://www.microeconomicsnotes.com/india/inflation/inflationary-gap-concept-criticisms-and-importance/1396