Inflationary Gap: Definition & Overview

Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

This lesson looks at what causes an inflationary gap. You will review aggregate demand and what happens when that demand outpaces supply at full employment. See how the gross domestic product is calculated and how it relates to aggregate demand.

Aggregate Demand

In this lesson, we are going to look at a key economic term called inflationary gap as it applies to a fake economy called the Sunflower Country. Sunflower Country is an island between Hawaii and Guam. Its primary good is pineapples and its primary service is tourism. There is a high demand in this economy for scooters. The climate is conducive to using scooters for transportation, sport, and recreation.

Before we use the demand for scooters as an example of inflationary gap, let's look at the definition of aggregate demand, a key part of the definition of inflationary gap. Aggregate demand is defined as the demand for all final goods and services in an economy. So, this would include pineapples, scooters, and anything else people want to purchase.

Gross Domestic Product

Aggregate demand is also what we know as gross domestic product (GDP). GDP, or aggregate demand, is the primary way that we define the health of an economy. For example, if consumers are wanting to buy scooters, there must be enough money circulating in the economy to prompt people to make these purchases. In simple terms, if we are buying a new scooter, we must have the money to do so.

Let's look at calculating GDP, which is calculated annually or quarterly. The standard formula is: C + I + G + (X-M) where:

C = Consumption of households

I = Investment from private entities

G = Government spending

X-M = Exports - Imports = Net exports

Let's say, for example, during 2016, Sunflower Country is at full employment. No one else in the economy is capable of working and no more production is possible. The households in the Sunflower Country economy consume $10 million worth of goods and services. Businesses invest $2 million in equipment. The government spends a total of $18 million. Also during 2016, the economy produces $5 million in net exports. GDP is calculated in millions as 10 + 2 + 18 + (5) = $35 million. Once we have our GDP, which is also our aggregate demand at full employment, we can look at what will happen if demand increases and outpaces supply.

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