Both natural forces and deliberate measures can close the inflationary gap created by excess expenditures, but the latter are considered more reliable and certain than the former.
The inflationary gap causes the prices to rise, but the price rise does nothing directly to eliminate the gap. However, there are a number of indirect effects of the price rise which tend to reduce the gap.
1. Keynes’ Effect:
When money supply is constant or rises in small proportions than prices, rate of interest will rise, tending to reduce the investment expenditure.
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2. Wealth Effect:
Higher prices may reduce consumption expenditure by reducing real wealth held in the form of government money and government debt.
3. Balance-of-Trade Effect:
Higher prices will lead to encourage imports and reduce exports.
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4. Fiscal Effect:
(i) If tax collections rise faster than prices, this will shift the consumption downward by reducing the real disposable income.
(ii) Transfer payments fixed in money terms become less significant in real terms, thus reducing consumption expenditure.
(iii) Real government purchase will also be reduced if budgets are fixed in money terms.
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5. Price Expectation Effect:
If the current rise in prices is expected to be temporary and to be followed by later reduction in prices, consumer buying of durables and investment in plant and equipment may be delayed and inventories reduced, thus narrowing the inflationary gap.
6. Redistribution Effect:
If money wage rates are fixed (or wage- adjustment gap exists), higher prices will go entirely to profits. Assuming the marginal propensity to consume of the profit earners less than that of the wage earners, a redistribution of income towards profits will tend to reduce aggregate demand and to narrow the inflationary gap.
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7. Money illusion Effect:
If some spenders suffer from money illusion and at least a part of their expenditure is fixed in money terms, inflation will reduce the real value of such expenditure and close the inflationary gap.
Rather than waiting for the natural forces to close the inflationary gap, fiscal policy can be used to reduce government expenditure and to increase taxes, thus to reduce the total expenditure in the economy.
In other words, government should incur a budget surplus. Monetary policy can also be directed towards decreasing the money supply. The Keynesians, however, doubt efficacy of monetary policy to deal with both inflationary and deflationary situations.