Acquired inflation gap

What Is Acquired Inflation Gap?

An Acquired Inflation Gap is a macroeconomic condition where an economy's actual output, measured by its real GDP, exceeds its potential GDP, which is the maximum sustainable output achievable at full employment. This phenomenon falls under the broader field of macroeconomics and indicates that the aggregate demand for goods and services within an economy has outstripped its productive capacity. When an Acquired Inflation Gap exists, it places upward pressure on prices, leading to inflation as consumers and businesses compete for limited resources.⁶⁷, ⁶⁸, ⁶⁹, ⁷⁰

This situation typically arises during periods of robust economic growth when consumer spending, investment, or government expenditure increases significantly. The term "acquired" emphasizes that this gap is a state the economy has entered due to demand exceeding supply at the full employment level, rather than a perpetual condition.⁶⁴, ⁶⁵, ⁶⁶

History and Origin

The concept of an inflationary gap, which an Acquired Inflation Gap closely mirrors, was notably introduced by British economist John Maynard Keynes in the 1940s. Keynes used this analytical tool to assess the risk of inflation, particularly in the context of financing wartime expenditures.⁶³ His work highlighted that when an economy operates beyond its full employment level, any further increase in aggregate demand primarily translates into higher prices rather than increased output, given that resources are already fully utilized.

Central banks, such as the Federal Reserve in the United States, were later established or evolved with mandates that include maintaining price stability alongside other goals, such as maximum employment. The Federal Reserve Act of 1913, which created the Federal Reserve System, sought to provide the nation with a more stable monetary and financial system, implicitly addressing concerns related to economic imbalances that could lead to inflationary pressures.⁶⁰, ⁶¹, ⁶² The Federal Reserve's dual mandate, formalized over time, includes achieving stable prices, which the Federal Open Market Committee (FOMC) currently defines as a 2% average inflation target for the Personal Consumption Expenditures (PCE) price index.⁵⁴, ⁵⁵, ⁵⁶, ⁵⁷, ⁵⁸, ⁵⁹

Key Takeaways

• An Acquired Inflation Gap occurs when actual economic output exceeds the economy's sustainable potential.⁴⁹, ⁵⁰, ⁵¹, ⁵², ⁵³
• It signifies that aggregate demand outpaces the economy's ability to produce goods and services.⁴⁶, ⁴⁷, ⁴⁸
• This imbalance leads to inflationary pressures as prices rise to clear the market.⁴², ⁴³, ⁴⁴, ⁴⁵
• Policymakers often employ contractionary monetary policy or fiscal policy to close an Acquired Inflation Gap.³⁸, ³⁹, ⁴⁰, ⁴¹

Formula and Calculation

The Acquired Inflation Gap, often simply referred to as an inflationary gap or expansionary gap, is calculated as the positive difference between the actual Gross Domestic Product (GDP) and the potential GDP of an economy.

$\text{Acquired Inflation Gap} = \text{Actual Real GDP} - \text{Potential GDP}$

Here:

• Actual Real GDP represents the total value of all goods and services produced in an economy over a specific period, adjusted for inflation.³⁷
• Potential GDP refers to the maximum sustainable output an economy can produce when all its resources (labor, capital, land, and entrepreneurship) are fully employed without generating accelerating inflation.³⁴, ³⁵, ³⁶

A positive result from this formula indicates the presence of an Acquired Inflation Gap.

Interpreting the Acquired Inflation Gap

When an Acquired Inflation Gap is present, it signals that an economy is "overheating." This means that the demand for goods and services is so strong that businesses cannot keep up with production using existing resources efficiently. Consequently, prices for goods and services rise as consumers are willing to pay more, and businesses may increase wages to attract scarce labor, further fueling price increases.³², ³³

The size of the Acquired Inflation Gap helps economists and policymakers gauge the severity of the inflationary pressure. A larger gap implies more significant pressure on prices. Understanding this gap is crucial for assessing the current state of the business cycle and predicting future inflation trends. It often prompts central banks and governments to consider measures to reduce aggregate demand to bring the economy back to its potential output level and achieve price stability.²⁸, ²⁹, ³⁰, ³¹

Hypothetical Example

Consider the hypothetical country of Econland, which has a potential GDP of $1 trillion per year. This represents the maximum output Econland can produce when all its factories are running optimally, all available workers are employed (at the natural rate of unemployment), and other resources are fully utilized without creating undue inflationary pressure.

However, due to a recent surge in consumer confidence and a significant increase in government spending on infrastructure projects, the demand for goods and services has soared. As a result, Econland's actual real GDP for the current year reaches $1.05 trillion.

In this scenario, the Acquired Inflation Gap for Econland is:

Acquired Inflation Gap = Actual Real GDP - Potential GDP
Acquired Inflation Gap = $1.05 trillion - $1 trillion = $50 billion

This $50 billion Acquired Inflation Gap indicates that Econland's economy is producing beyond its sustainable capacity, leading to excess demand. This excess demand will likely translate into rising prices across various sectors of the economy, as businesses may struggle to meet the heightened demand without increasing their costs.

Practical Applications

The concept of an Acquired Inflation Gap is highly relevant for policymakers and economic analysts, particularly in the realm of macroeconomic management.

• Monetary Policy: Central banks, like the Federal Reserve, closely monitor inflationary gaps. If an Acquired Inflation Gap is identified, the central bank may implement contractionary monetary policy. This typically involves raising benchmark interest rates, which makes borrowing more expensive for businesses and consumers, thereby reducing investment and consumption and curbing aggregate demand. This helps to cool down an overheating economy and bring inflation back to target levels. The International Monetary Fund (IMF) regularly assesses global inflation trends and forecasts, noting how central bank actions aim to restore price stability.²⁴, ²⁵, ²⁶, ²⁷ Recent Reuters polls, for instance, highlight central bank efforts globally to tame inflation even amidst supply chain disruptions.²¹, ²², ²³
• Fiscal Policy: Governments can also use fiscal policy to address an Acquired Inflation Gap. This involves decreasing government spending or increasing taxes. Both measures reduce the total amount of money circulating in the economy, thereby lowering aggregate demand and alleviating inflationary pressures.¹⁹, ²⁰
• Economic Analysis: Economists utilize the Acquired Inflation Gap to diagnose the health of an economy within its business cycle. A persistent positive gap suggests an economy that may be experiencing unsustainable growth, which could eventually lead to severe inflation or subsequent sharp economic contractions. Data from sources like the Federal Reserve Bank of San Francisco help disaggregate supply- and demand-driven components of inflation, aiding in a more nuanced understanding of these gaps.¹⁸

Limitations and Criticisms

While the concept of an Acquired Inflation Gap is a fundamental tool in macroeconomics, it is not without limitations or criticisms.

One primary challenge lies in accurately measuring potential GDP. Potential GDP is a theoretical construct and cannot be directly observed. It is estimated based on assumptions about an economy's productive capacity, full employment levels, and technological advancements. These estimates can vary among economists and institutions, leading to different interpretations of whether an Acquired Inflation Gap truly exists or how large it might be. Inaccuracies in this estimation can lead to policy missteps, where policymakers might implement contractionary measures based on an overestimated gap, potentially slowing economic growth unnecessarily, or conversely, failing to act when inflationary pressures are building.

Furthermore, the responsiveness of the economy to policy interventions can be unpredictable. Factors such as consumer and business expectations, global economic conditions, and the time lag between policy implementation and its effects can complicate efforts to close an Acquired Inflation Gap smoothly. For instance, unanticipated supply shocks can contribute to inflation independent of an Acquired Inflation Gap, making it harder for central banks to gauge the appropriate policy response.¹⁶, ¹⁷ The effectiveness of monetary policy in addressing such gaps has been debated, particularly concerning its ability to influence specific sectors or manage expectations.

Acquired Inflation Gap vs. Recessionary Gap

The Acquired Inflation Gap and the Recessionary Gap represent two opposite phases within the business cycle. Both are types of "output gaps" that indicate a deviation between an economy's actual performance and its full-employment potential.¹⁵

An Acquired Inflation Gap occurs when the actual real GDP is greater than the potential GDP. This signifies that aggregate demand is exceeding the economy's productive capacity at full employment, leading to upward pressure on prices and inflation. It is characterized by low unemployment and a rapidly expanding economy.¹⁰, ¹¹, ¹², ¹³, ¹⁴

Conversely, a Recessionary Gap (also known as a deflationary gap) happens when the actual real GDP falls below the potential GDP. In this scenario, there is insufficient aggregate demand to fully employ all available resources, resulting in high unemployment, underutilized capacity, and downward pressure on prices or even deflation. Policymakers typically employ expansionary monetary policy or fiscal policy to close a recessionary gap.⁸, ⁹

In essence, an Acquired Inflation Gap signals an economy that is "overheating," while a Recessionary Gap indicates an economy that is "underperforming" its potential.

FAQs

What causes an Acquired Inflation Gap?

An Acquired Inflation Gap is primarily caused by an excess of aggregate demand over the economy's sustainable aggregate supply at full employment. This can stem from factors such as increased consumer spending, higher business investment, significant government expenditure, or strong export demand.⁵, ⁶, ⁷

How does an Acquired Inflation Gap affect individuals?

For individuals, an Acquired Inflation Gap translates into rising prices for goods and services, meaning their purchasing power decreases if wages do not keep pace. While unemployment may be low, the erosion of real income due to inflation can negatively impact living standards and savings.

What measures can be taken to close an Acquired Inflation Gap?

To close an Acquired Inflation Gap, policymakers typically employ contractionary economic measures. A central bank might raise interest rates to reduce borrowing and spending (tight monetary policy). A government might reduce its spending or increase taxes (contractionary fiscal policy). The goal is to reduce aggregate demand to a level consistent with the economy's potential GDP.¹, ², ³, ⁴