Chapter 9 · Aggregate demand and aggregate supply
Inflationary gap
Identify an inflationary gap when real GDP temporarily exceeds potential output. Explain the pressure on wages, production costs and prices.
The economic idea
The monetarist/new classical model assumes that the economy has a potential level of output determined by the quantity and quality of productive resources, technology and institutions. In the long run, the average price level does not determine this productive capacity.
Long-run aggregate supply is therefore vertical at potential output. It shows the real output the economy can produce sustainably when labour and other resources are employed at their normal full-employment rates.
Short-run macroeconomic equilibrium occurs where aggregate demand intersects short-run aggregate supply. A long-run equilibrium occurs only when that intersection is also on LRAS, so actual output equals potential output.
An output gap is the difference between actual real GDP and potential real GDP. A recessionary gap exists when actual output is below potential; an inflationary gap exists when actual output is above its sustainable level.
An inflationary gap indicates that the economy is operating beyond sustainable capacity. Overtime, labour shortages and intensive resource use raise nominal wages and other input costs.
Reading inflationary gap from E and LRAS
“Price level” measures the average price level and “Real GDP” measures real GDP.
“AD” and “SRAS” determine the short-run equilibrium “E”, with price level “PLₑ” and actual output “Yₑ”.
“LRAS” is vertical at potential output. Its horizontal position, not its height, is the benchmark for sustainable productive capacity.
Short-run position: E
“E” is the intersection of “AD” and “SRAS”. It is the point at which planned expenditure equals firms' short-run planned output.
Long-run benchmark: LRAS
“LRAS” marks potential output. Moving the price level up or down does not move the economy along this vertical curve because long-run output is governed by productive capacity rather than the average price level.
The gap shown now
“E” lies to the right of “LRAS”, so “Yₑ” is above the economy's sustainable potential output. The current graph shows an inflationary gap: resources are overused and upward pressure on wages and prices is likely.
How can output exceed potential?
Potential output is a sustainable benchmark. Firms can temporarily produce more by using overtime, running equipment intensively or postponing maintenance. This does not mean productive capacity has permanently increased.
Explain the pressure on scarce labour and other inputs before linking the gap to rising costs. The diagram shows a reason for inflationary pressure; it does not measure an inflation rate or tell us how long the pressure lasts.
How the output gap creates its own adjustment pressure
At “E”, output lies beyond the position of “LRAS”, so firms are using resources above normal sustainable rates.
Labour shortages, overtime and intense use of inputs place upward pressure on nominal wages and production costs.
Higher unit costs decrease short-run aggregate supply, shifting “SRAS” left/up until equilibrium returns to “LRAS”.
Real output falls back to potential while the price level rises, assuming aggregate demand and productive capacity do not change.
Common mistakes to avoid
- The intersection of “AD” and “SRAS” is always a short-run equilibrium, but it is a long-run equilibrium only when it lies on “LRAS”.
- Full employment does not mean zero unemployment. Frictional and structural unemployment can remain at potential output.
- A recessionary gap is a shortfall of actual output below potential output, not a shaded welfare loss or the size of a fall in GDP over time.
- An inflationary gap does not mean the economy can sustain extra output forever; it represents output above its normal sustainable level.
- A change in the price level does not shift “LRAS”. Productive resources, technology and institutions determine its position.
How to draw this diagram
- Title the diagram “Inflationary gap”. Label the horizontal axis “Real GDP” and the vertical axis “Price level”.
- Draw AD first and label it clearly.
- Draw SRAS next and label it clearly.
- Draw LRAS next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- Potential output cannot be observed directly and must be estimated, so the measured output gap is uncertain.
- Nominal wages and input prices may be sticky because of contracts, minimum wages, bargaining, morale and imperfect information.
- A prolonged recession can reduce investment and skills, shifting potential output left through hysteresis rather than leaving LRAS fixed.
- An inflationary period can induce investment, migration or participation changes that alter capacity rather than producing only price adjustment.
- The aggregate model hides sectoral bottlenecks and regional unemployment that can coexist within the same national output gap.