inflationary gaps

Introduction

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.

Over the last ten years the output gap (the estimated difference between actual and potential GDP) has remained very low – helping to control any demand-pull inflationary pressure in the economy. The chart above shows that following the last recession, the output gap was negative with actual GDP well below potential (i.e. there was plenty of spare capacity to meet increases in aggregate demand). By the late 1990s, this output gap had eroded – but the Bank of England has striven to keep the growth of AD close to the long term trend rate of growth and it seems to have reasonably successful in this ambition. The output gap turned negative in 2002 following a slowdown in real GDP growth.