Inflationary gap
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An inflationary gap, in economics, is the amount by which the real Gross domestic product, or real GDP, exceeds potential GDP.[1] The real GDP is also known as GDP "adjusted for inflation", "constant prices" GDP or "constant dollar" GDP, because it measures the aggregate output in a country's income accounts in a given year, expressed in base-year prices. On the other hand, the potential GDP is the quantity of real GDP when a country's economy is at full-employment.
When an initial increase in aggregate demand produces inflation (so called demand-pull inflation) and real GDP increase, the price level and real GDP are determined at the point where the new aggregate demand and the short-run aggregate supply meet. This point is known as above full-employment equilibrium[1], since the short-run aggregate supply is above the long-term aggregate supply, i.e. above the aggregate supply at full employment. The gap created between real GDP and potential GDP is the consequence of inflation and that is why it is called the inflationary gap.
Obviously, this situation cannot last forever, because there is a shortage of labour. The shortage of labour produces the rise of wage rates, which makes the short-run aggregate supply decrease, until it reaches the full-employment level. The short-run aggregate supply decrease makes an upward pressure on the price level, consequently causing inflation. The once created gap between real GDP and potential GDP was the sign of forthcoming inflation and that is why it is called the inflationary gap.
See also Recessionary gap. CORRECTION -
The inflationary gap is the current inflation minus the inflation target.
The output gap is the current GDP minus the potential GDP.
