Imagine a situation in which 10 year old kid is given so many tonics & supplements, so that he start working like a 25 year old guy.
This is same method used by government to make economy more mature and responsible. Government introduce more and more money in economy to increase the production level. This intended production level is to satisfy future demand of economy.
Definition: The gap between the actual output & potential output is known as inflationary gap.
Before explaining the actual output and potential output, imagine 10 year old output as potential output & after supplements, the grown up boy output as actual output.
That is in a certain period, an economy output (or income) increase from potential output to actual output.
Of course this actual output exceeds the potential output, that is why when we subtract 2nd from 1st our answer is in negative.
Let us name potential output, the output at full employment (Not everyone is working, as some quit job, some are in process of getting a new job, some lost their seasonal job) as Output (fe).
The output after increased expenditure (giving supplements) as Output (a).
Output (fe) – Output (a) = – (or negative). This is known as inflationary gap.
This is half part of story, meaning govt. increased expenditure to raise the production level has a result. Result of inflation in products price in economy.
Let us see how inflation occurs.
Consider situation 0, in which demand and supply matched (Full employment equilibrium)
Now extra money enters or more expenditure by govt starts.
This extra money create more demand.
Till the time, Factor of Production do not multiply or increase, the existing factor of production have to work more and more to fulfill this demand. Resources are now being utilized more and over capacity, labor are working more, to fulfill this new demand, more operational cost for businesses etc.
Let’s say this extra supply meet this increased demand at situation 1(Above full employment equilibrium).
At situation 0 = Demand (0) and supply (0) Full employment equilibrium.
At situation 1 = Demand (1) and supply (1) Above full employment equilibrium.
If demand and supply already matched, why the hell, is inflation going to appear ?
Inflation will appear as this increased short-term supply by over utilized resources won’t continue for long. Consider this, labor earlier working for 8 hours, now have to work overtime. This will create demand for more wage & bring down our short-term increased supply. Thus demand remain high and supply can’t keep up with it. The result is inflation.
Note: Some author do a blunder by naming the extra expenditure of govt as inflationary gap. This is wrong. As you read above, it is the effect or the result of extra expenditure. The result is inflation.
Question ) At some date, the output (Potential GDP) is going to match with the level of expenditure in economy. How can inflationary gap exist then ?
Answer ) The expenditure by govt. is not one time but continuous, with aim of increasing economic activities. When it will start coming to match, there will be more expenditure again. **Until this expenditure turn into no growth and only inflation scenario which is stagflation**