An inflationary gap occurs when an economy’s actual output exceeds its potential output, leading to upward pressure on prices. To illustrate this, we can use a graph that includes the Long-Run Aggregate Supply (LRAS), Short-Run Aggregate Supply (SRAS), and Aggregate Demand (AD) curves.
In the graph, the LRAS curve is vertical, representing the economy’s potential output at full employment. The AD curve slopes downward, reflecting the negative relationship between price levels and the quantity of goods demanded. The SRAS curve slopes upward because, in the short run, as prices rise, producers are willing to supply more goods.
To demonstrate an inflationary gap:
- The AD curve will shift to the right, indicating an increase in overall demand.
- The new equilibrium point, where the new AD curve intersects the SRAS curve, establishes a higher price level and a real GDP that is above the potential GDP.
In the diagram, the distance between the new equilibrium output and the LRAS represents the output gap, which reflects the economy’s excess demand.
Overall, in this scenario:
- The equilibrium price level is shown at the intersection of the new AD and SRAS curves.
- The real GDP is at the point of intersection, which is greater than the potential GDP indicated by the LRAS.
- The output gap is the difference between the actual output (real GDP) and the potential output (LRAS).
This situation suggests that the economy may face inflationary pressures leading policymakers to consider measures to reduce demand.