When aggregate demand exceeds an economy's productive potential there is an inflationary gap. We tend to see rising inflation and a worsening trade situation at these times. This situation occurs when the economy has been growing for some time leading to a build up of inflationary pressure as demand rises. In the late 1980s there was a cyclical boom in the economy that led to a large inflationary gap. Consumer demand increased by over 7.5% in real terms during 1988 and the economy was clearly over-heating with demand running ahead of the ability of the economy to supply goods and services. Controlling an inflationary gap
The government may use monetary and or fiscal policy to help reduce the size of the inflationary gap. This would involve controlling total spending by either increasing interest rates or raising taxation. • An improvement in the supply-side performance of the economy would also achieve this. • Monetary Policy: Higher interest rates to curb consumer demand • Fiscal Policy: A rise in the burden of taxation to reduce real disposable incomes • Supply-side Policy: Measures to increase productivity and efficiency. This leads to a rise in aggregate supply and reduces the amount of excess demand in the long run. Inflationary gaps can arise when the economy has grown for a long time on the back of a high level of aggregate demand. Total spending may rise faster than the economy's ability to supply goods and services. As a result, actual GDP may exceed potential GDP leading to a positive output gap in the economy. Deflationary gap
A deflationary gap exists when there is insufficient demand available in the economy to generate full-employment equilibrium. In other words there is not enough being bought to provide jobs for everyone who wants them. Full employment level of national income means the level of output attained when unemployment is at a socially acceptable level. In most cases this is around 5% however it tends to vary. If...
Please join StudyMode to read the full document