An Inflationary Gap is an economic idea that is used to measure the gap between the current amount of real gross domestic product (GDP) and the GDP that would be achieved in a world economy operating in fully employed.
Understanding the Inflation Gap
A gap in inflation occurs where the need for services and goods is greater than production because of factors like higher levels of employment overall and an increase in trading activity, and increased public expenditure.
With this in mind that the real GDP may outstrip what is possible GDP leading to the existence of an inflationary gap. The term “inflationary gap” is used in this way because the rise in real GDP leads for an the economy to expand its consumption which causes prices to rise over time.
Then, the actual GDP is Y/D. D will be D is the the GDP inflation rate which brings inflation into account over time.
A rise in the consumption of and government expenditure, investment or net exports cause real GDP to grow in the short term. Real GDP is a measure of economic growth, while compensating for the negative effects from the effects of inflation as well as the effects of deflation. This results in a figure that reflects the difference between the actual growth in economic activity and a simple change in the cost of products or services in the economy.
Fiscal Policy and Monetary Policy to Control the Inflationary Gap
A government can choose to implement the fiscal policies to reduce the gap in inflation, usually by reducing the amount of money flowing through the economy. This could be achieved through the reduction of government expenditure and tax increases, bonds and securities issue, and reductions in transfer payments.
The adjustments to economic fiscal environment could help bring back the equilibrium of the economy. When the quantity of money in circulation decreases, general consumption of goods and other services diminishes as well, which reduces inflation.
Central banks also have tools available to stop inflationary activity. In the event that you have the Federal Reserve (Fed) increases the interest rate this makes borrowing money more expensive.
The tightening of monetary policy could eventually decrease amounts of cash accessible to consumers in general, resulting in lower prices and demand, or inflation to slow. When equilibrium is achieved and the equilibrium is reached, the Fed or another central banks could then adjust rates of interest according to.