Keynes, in his pamphlet entitled How to pay for the War, 1940 explained inflation in terms of inflationary gap. According to him, inflationary gap exists when, at full employment income level, aggregate demand exceeds aggregate supply.
This means that due to increase in investment and government expenditure, the money income increases, but production does not increase because of the limitations of productive capacity.
As a result, an inflationary gap comes to exist, causing the prices to rise. The prices continue to rise so long as the inflationary gap exists. Prof. Kurihara defined inflationary gap “as an excess of anticipated expenditure over available output at base prices.”
An inflationary gap arises when a government chooses to finance even its normal expenditure through monetary expansion in a time of full employment.
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It can also occur during a strong private investment boom (such as might result from massive innovations, opening of new territory, etc.) if the monetary authorities are willing to accommodate increased demand for money.
However, the important cases of inflationary gap are those associated with the government expenditure on war or war preparations.
To illustrate the concept of inflationary gap, let us take the example of a wartime economy. On the supply side, suppose the value of gross national product is Rs. 800 crores at pre- inflation prices.
If, out of this, the government takes away output worth Rs.150 crores for war purposes, an output worth Rs 650 crores is left of civilian consumption. Thus, Rs. 650 crores is the value of available supply of goods for civilian consumption.
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Now take the demand side. Suppose that the money income paid to the various factors of production is Rs. 1000 crores.
If, out of this money income, the government takes away Rs.100 crores by way of taxes, the total disposable income left with the people will be Rs. 900 crores.
Again, if the community keeps Rs. 50 crores as saving, then the net disposable income will be Rs. 850 crores. This is the actual money income with the community for spending purposes.