Inflationary Gap

The aggregate market presented in the graph to the right can provide an understanding of an inflationary gap. The vertical long-run aggregate supply curve, labeled LRAS, marks full-employment real production. Long-run equilibrium in the aggregate market necessarily results in full-employment real production.

The positively-sloped short-run aggregate supply curve is labeled SRAS. Short-run equilibrium in the aggregate market occurs at the price level and real production corresponding to the intersection of the aggregate demand curve and this SRAS curve. Should short-run real production exceed full-employment real production, then an inflationary gap results. However, to identify an inflationary gap an aggregate demand curve needs to be added to the graph.

To include the aggregate demand curve and illustrate an inflationary gap for this aggregate market, click the [Inflationary Gap] button. Doing so reveals a short-run equilibrium level of real production that is greater than full employment, which is an inflationary situation. Note that the aggregate demand curve, labeled AD, intersects the SRAS curve at a real production level to the right of the LRAS curve. This means the short-run real production is greater than full-employment real production. The difference between short-run equilibrium real production and full-employment real production is the inflationary gap.

The basic reason for the emergence of an inflationary gap is a short-run imbalance between resource prices, especially wages, and the price level. With real resource prices out of balance, labor and other resources are enticed to exceed their full-employment levels, which prompts subsequent increases in wages and prices, and hence inflation.

The primary problem associated with an inflationary gap is, of course, inflation. This tends to reduce the purchasing power of financial assets and can cause the haphazard redistribution of income and wealth. To avoid these problems of inflation, government often considers alternative stabilization policies to correct the situation, including contractionary monetary and fiscal policies. The intent of such policies is to decrease the short-run real production level and move it back to the long-run full-employment level of real production.