A deflationary gap or the output gap is the difference between actual GDP or actual output and potential GDP. The calculation for the output gap is Y–Y* where Y is actual output and Y* is potential output. If this calculation yields a positive number it is called an inflationary gap and indicates the growth of aggregate demand is outpacing the growth of aggregate supply—possibly creating inflation; if the calculation yields a negative number it is called a recessionary gap—possibly signifying deflation.
An inflationary gap, in economics, is the amount by which the actual gross domestic product exceeds potential full-employment GDP. It is one type of output gap, the other being a recessionary gap.
The concept of the inflationary gap was first given by John Maynard Keynes in his work How to Pay for War? (1940) this method was basically employed to study and solve problems regarding war finance. Keynes starts the analysis of the inflationary gap from the level of full employment equilibrium whereas his other analyses are based on under-employment equilibrium. The main cause of the gap is considered to be expansionary monetary policies carried out by the government. An inflationary gap is a signal that the economy is in the boom part of the trade cycle, resources are being used over their capacity, factories are operating with increasing average costs; wage rates increase because labour is used beyond normal hours at overtime pay rates. A case of the gap can arise when consumer or investor spending is very buoyant, when foreign demand is increasing or when government expenditure increases. According to some economists, such a situation arose in the United States in 1999-2000 and 2006-2007, when the unemployment rate was below 5%. Wages increase as a result of the increase in aggregate demand which in turn raises business costs. This leads to an increase in prices (inflation) and these higher prices reduce consumer purchasing power, causing aggregate demand to fall and the output gap to close. When the gap is finally eliminated, equilibrium is achieved, with actual GDP equal to potential GDP but at a higher price level. Economists warn that this is not an auto mechanism.
Government action in the form of fiscal and monetary policies is a must to close the gap. Monetary policy can be used to contract the money supply in the economy by raising interest rates, which would reduce purchasing power, resulting in falling demand. Keynes, however, was not in favor of monetary methods. He suggested a method of progressive taxation, where the collections from the taxes would be saved and used once equilibrium is achieved in the economy, which he called 'forced savings' Another method is to cut transfer payments and subsidies, thus cutting down consumption.