Explain the concept of inflationary gap with the help of a diagram. Discuss two monetary measures to correct it.
Answers
Inflationary Gap Explained
The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The inflationary gap is so named because the relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run.
Due to the higher number of funds available within the economy, consumers are more inclined to purchase goods and services. As the demand for goods and services increases but production has not yet compensated for the shift, prices rise to restore market equilibrium. When the potential GDP is higher than the real GDP, the gap is referred to as a deflationary gap.