Which of the following is not a method to reduce the inflationary gap

Understanding Inflationary Gap

An inflationary gap requires two common macroeconomic variables: GDP and unemployment.

Gross domestic output (GDP) measures the economic output over a specific time frame. Potential GDP refers to the GDP achievable if the economy was operating at full employment.

Contrary to popular belief, full employment does not mean zero unemployment. Rather, it implies the absence of demand-deficient unemployment – the involuntary unemployment as a result of a contraction period.

Full unemployment still contains other types of unemployment inherent in market economies, such as structural unemployment and frictional unemployment. Structural unemployment exists where there is an imbalance of jobs available and workforce skill levels. In contrast, frictional unemployment is temporary unemployment due to workers quitting their jobs to find new ones.

GDP can be understood as the aggregate supply in the economy. It constantly fluctuates in the short term but always reverts to long-term mean growth, as illustrated by the orange line in the graph below.

The business cycle represents the fluctuations in GDP, and the inflationary gap occurs when the business cycle is in the expansionary period. On the other hand, a recessionary gap is when the difference between the real GDP and potential GDP is negative, corresponding to the contraction period in the business cycle.

Inflationary Gap Economics

In the short run, aggregate supply is upwards sloping because companies are willing to increase supply when prices increase. However, in the long run, aggregate supply is vertical because supply is not related to price but rather the economy’s available resources.

The long-run aggregate supply (LRAS) is stabilized at the potential GDP with full employment. The real GDP is denoted as the intersection of short-run aggregate supply (SRAS) and aggregate demand (AD).

When there is an inflationary gap, the short-run aggregate supply intersects the aggregate demand to the right of the long-run aggregate supply. The positive difference between the real GDP and the potential GDP on the x-axis is the inflationary gap.

On the other hand, when there is a recessionary gap, the short-run aggregate supply intersects the aggregate demand to the left of the long-run aggregate supply, and the difference between the real GDP and potential GDP is negative.

As theorized by economists, the fundamental cause of inflationary gaps is expansionary monetary policy. As the central bank spurs the economy, the excess demand in the short run pushes price levels up to create inflation. To meet the increased demand, suppliers increase inputs and human capital, creating an expansionary economic period.

However, if the business cycle deviates too far from the mean, the consequences are an extremely volatile economy with very high peaks accompanied by very low troughs. To ensure economic stability, the government intervenes through monetary and fiscal policy to guide the economy towards equilibrium.

If the government wishes to decrease the inflationary gap, it can influence the demand side with contractionary monetary policy by raising interest rates and decreasing the money supply. From the supply side, they can implement contractionary fiscal policy through increasing taxes and decreasing government expenditure. The combined economic policies will cool down unsustainable economic growth and prevent severe recessions.

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During an inflationary expenditure gap, the total spending hikes due to a pull in prices by heavy consumer demand. The demand has to be cut down to reduce the inflationary gap. The economy's aggregate demand can be reduced either by increasing the taxes or decreasing government spending or both simultaneously.

Higher taxes will minimize the disposable income of consumers, and the consumption expenditure will decline, which will ultimately reduce the aggregate demand or expenditure in the economy. The inflationary output gap will be minimized.

Decreased government spending will directly shrink the economy's aggregate expenditure. As aggregate expenditure declines, the price level will also decline, which reduces the inflationary gap.

An inflationary gap is a macroeconomic concept that measures the difference between the current level of real gross domestic product (GDP) and the GDP that would exist if an economy was operating at full employment.

• An inflationary gap measures the difference between the current level of real GDP and the GDP that would exist if an economy was operating at full employment.
• For the gap to be considered inflationary, the current real GDP must be higher than the potential GDP.
• Policies that can reduce an inflationary gap include reductions in government spending, tax increases, bond and securities issues, interest rate increases, and transfer payment reductions.

An 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 elevated government expenditure.

Against this backdrop, the real GDP can exceed the potential GDP, resulting in an inflationary gap. The inflationary gap is named as such because the relative rise in real GDP causes an economy to increase its consumption, leading prices to climb in the long run.

For the gap to be considered inflationary, the current real GDP must be higher than the economy-at-full-employment GDP—also known as potential GDP.

The inflationary gap represents the point in the business cycle when the economy is expanding. Due to the higher number of funds available within the economy, consumers are more inclined to purchase goods and services. As 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 instead referred to as a deflationary gap. The other type of output gap is the recessionary gap, which describes an economy operating below its full-employment equilibrium.

According to macroeconomic theory, the goods market determines the level of real GDP, which is shown in the following relationship. To calculate real GDP, first compute the nominal GDP:

Where:

• Y = nominal GDP
• C = consumption expenditure
• I = investment
• G = government expenditure
• NX = net exports

Then, the real GDP = Y/D, where D is the GDP deflator, which takes inflation into effect over time.

An increase in consumption expenditure, investments, government expenditure, or net exports causes real GDP to rise in the short run. Real GDP provides a measure of economic growth while compensating for the effects of inflation or deflation. This produces a result that accounts for the difference between actual economic growth and a simple shift in the prices of goods or services within the economy.

A government may choose to use fiscal policy to help reduce an inflationary gap, often through decreasing the number of funds circulating within the economy. This can be accomplished through reductions in government spending, tax increases, bond and securities issues, and transfer payment reductions.

These adjustments to the fiscal conditions within the economy can serve to restore economic equilibrium. As the amount of money in circulation decreases, the overall demand for goods and services declines, too, reducing inflation.

Central banks also have tools at their disposal to combat inflationary activity. When the Federal Reserve (Fed) raises interest rates, it makes borrowing funds more expensive.

Tight monetary policy should subsequently lower the amount of money available to most consumers, triggering less demand and prices or inflation to retreat. Once equilibrium is reached, the Fed or other central bank can then shift interest rates accordingly.