What is the Keynesian Concept of Inflationary Gap?

The concept of inflationary gap is a tool for analysing, theoretically as well as calculating statistically, the pressure of inflation. The concept of “inflationary gap” was originated by Keynes in his pamphlet.

How to pay for the War, by functionally relating expected expenditure to disposable income in relation to the value or available output, at base prices (or constant prices).

The concept was developed not only to emphasise the strategic significance of the flow of the money incomes in influencing the general price level but also to stress the primary importance of fiscal measures such as taxes and public borrowings, with the intention of wiping out the inflationary gap.

The inflationary gap in the economy as a whole may be defined as an excess of anticipated total expenditures over the money value of available output at base prices (or constant prices). The anticipated total expenditure of the community is composed of aggregate consumption, investment and government outlays. Thus,

Total anticipated expenditure = C + I + G, Where,

C = consumption outlay

I = Investment outlay, and

G = government outlay on goods and services.

The supply of goods or services (or the available output), on the other hand, is a function of the conditions of employment plus the technological structure.

When, owing to an increased investment only (I) or government expenditure (G) or both, money income rises, but due to limitations of the capacity to produce real income, the supply of goods and services does not increase in the same proportion and an inflationary gap develops causing price to rise. These prices continue to rise so long as this gap persists.

According to Bent Hansen, an inflationary gap is the result of excess demand.

Excess demand = Active attempts to purchase – Available quantity of goods.

So long as goods are available in plenty at the existing level of prices, the problem of inflationary gap will not rise. But inflation starts when increasing private investment or public outlay raises disposable money income to a level beyond which no increase in real income, i.e., production of goods and services, is possible.

Theoretically, this will be a full-employment phenomenon because only under full-employment conditions, a further rise in money income and the resulting increase in expenditure or effective demand cannot cause an expansion in output; consequently prices will tend to rise.

Statistical Measurement:

The statistical measurement of inflationary gap may be illustrated by taking a simple war-economy model as under, which for our purposes, is approximately a full employment economy model.

In a simple model, the value of gross national product is determined by an aggregate of consumption expenditure (C) plus private net investment (I) plus government expenditure (G) on goods and services. Let us suppose this amounts to Rs. 1,000 crores (total output valued at existing prices).

Now, if out of this total output, the government takes away output worth Rs.250 crores for war purposes, only Rs.750 crores worth of output is available for civilian consumption. Thus, Rs.750 crores constitutes the supply side of real goods and services. Rs.750 crores is the value of the available quantity of goods.

Next, we come to the demand side. If prices are not to raise, the incomes paid out to private individuals and institutions should be in proportion to the value of goods at prevailing prices; money income paid out must also be Rs.750 crores.

If the economy is paying out money income at the rate of Rs.1,100 crores by using past income or by creating new purchasing power and out of this government taxes take away Rs.100 crores, the total disposable income left with the community would then be Rs. 1,000 crores, the net disposable income becomes Rs. 900 crores.

This is the amount of money income which is available for spending. But the total civilian goods amount to Rs. 750 crores at the old prices (or base prices) and, when the disposable income of Rs. 900 crores is released to compete with available output of Rs. 750 crores, an inflationary gap of Rs. 150 crores inevitably emerges. This process is summarised as follows.

A similar inflationary gap can arise during a period of development planning. In a planning era, the amount of money expenditure and consequently, money income will rise, but the volume of consumption goods produced may not increase correspondingly (because of the time lag involved in the round-about method of production and due to the existence of bottlenecks in the economy). Therefore, an inflationary gap may come into existence.

The basic fact is that so long as the amount of disposable income in the community and the amount of goods available are the same, there will be price stability, but when the former is more than the latter, an inflationary gap will appear. If, on the other hand, the volume of goods exceeds the disposable money income, a deflationary gap will appear.

Graphical Exposition:

The concept of inflationary gap can also be illustrated by means of a diagram (see Fig. 7). In the diagram, the vertical axis measures the total anticipated expenditure and the horizontal axis measures real income (Gross National Product).

Consumption expenditure is denoted by C, private investment expenditure is denoted by I and G represents government expenditure, so that the total expenditure in the economy is denoted by the C + I + G function.

The 45° line is the equilibrium line, showing that the economy is in equilibrium when the supply of goods and services (as reflected in real income) equals the demand for them (as reflected in the total spending function).

Thus, the C + I + G curve intersect the equilibrium at point E _t , which gives us equilibrium income Y _f . Here Y _t is assumed to be the full employment income at current prices. Income Y _f corresponds to the value of total goods available at a given price level.

Here, the aggregate monetary demand, reflected by the C + I + G function, amounts to E _f Y _f equal to total availability of goods amounting to OY _f . At this point, there is a perfect harmony between the money income and real income equilibriums. As there is no excess demand, there is no problem of any inflationary gap.

Suppose, for some reason, the government is induced to increase its expenditure by a certain amount, say E _f E ₀ as indicated in the diagram, thereby raising the total government outlay from the previous level of C to G ₁ We get the new function, C + I + G’.

Since Y _f is the real income at the full-employment level, it does not increase with increased G which is E _f E _o . In that case, E _f E _o represents an excess of monetary demand over the available quantity of goods OY _f . Thus, E _f E _o is regarded as an inflationary gap, forcing up prices.

It occurs when, with the economy at full-employment, the flow of money income is increased more rapidly than is the output of goods and services. When expenditures rise faster than the output of goods and services, prices will necessarily rise, in order to equate expenditure with the money value of output at a higher price level.

Therefore, the inflationary gap is defined as the amount by which full employment exceeds the value of current output at existing prices. This implies that, to keep prices constant, output should increase by an amount that might be sufficient to absorb the excess demand generated expenditure.

Prices can remain constant only if real income increases from Y _r to Y _x , that is, by an amount shown by Y _f Y _X , which is equal to an excess demand E ₁ E _o on account of increased government expenditure. Thus, in order to wipe out inflation (E _f E _o ), real income should increase from Y _f to Y _x .

Significance of Inflationary Gap:

The significance of the inflationary gap lies in its effect upon national income. If an inflationary gap exists, such as E ₁ E _o at full-employment level OY, the money value of national income must be increased.

More money enters the income stream by way of increased expenditure. But total employment cannot be increased as full employment level has already been reached by the economy.

Thus, all that happens is that prices rise, so that the same quantity of goods and services is produced, but is sold for more monetary units or rupees. Thus, the inflationary gap is the direct cause of a fall in the value of money.

It greatly helps monetary and fiscal authorities to formulate appropriate and effective anti-inflationary policies, and to adopt suitable measures, if they visualise the inflationary potential well in time through the measure of the inflationary gap.

According to Kurihara, “analysis of the inflationary gap in terms of such aggregates as national income, investment outlays and consumption expenditures, clearly reveals what determines public policy with respect to taxes, public expenditures, saving campaigns, controlled wage adjustments in short, all the conceivable anti-inflation measures affecting the propensities to consume, to save and to invest, which together determine the general price level.”

Analysis of Inflationary Pressures:

By and large, inflation is initiated and sustained by an excess of spending in the economy. When everybody in the economy firms, households, government tries to spend more than the value of the available goods in the economy over a period of time, prices in general will rise.

Inflationary pressures in an economy, thus, arise from both the demand side and the supply side. In this context, by demand is meant the demand of money income for goods and by supply is meant the available output for which the money income can be spent.

Demand Side:

According to Kurihara, on the demand side, the major inflationary factors are:

(a) money supply, (b) disposable income, (c) consumer expenditures and business outlays, and (d) foreign demand.

1. Money Supply:

In the monetarists’ view, inflation is directly linked to changes in the money supply (M). An increase in money supply increases money income, thereby causing the monetary demand for goods and service to rise. Money supply can increase in the following ways:

(a) By the government resorting to deficit financing through the creation of new money, that is printing more paper notes;

(b) By the increase in the public’s demand deposits as a result of government expenditure; and

(c) By the expansion of bank credit.

2. Disposable Income:

When the net disposable money income of people increase, monetary demand for real goods and services rises. Net disposable money income can rise in the following ways:

(a) When taxes are lowered, the disposable income of people will rise, particularly in a post-war period when additional taxes are withdrawn;

(b) The tax level remaining unchanged, disposable income will rise when the national income grows; and

(c) The disposable income will rise when the savings ratio is lowered at a given income or when it remains constant with rising income.

3. Consumer Expenditure and Business Outlay:

When consumer spending and business outlay increase, obviously, the monetary demand for consumption goods and capital goods increases.

The consumers’ rate of spending can increase in the following ways:

(a) Household consumption is a function of disposable income. When the latter increases, the amount of disposable expenditure increases which, in turn, results in an increase in the absolute amount of consumption expenditure.

(b) By a reduction in current savings, the consumer’s demand is greatly stimulated.

(c) By the use of accumulated savings, consumers’ expenditure can increase.

(d) The possession of liquid assets such as bonds and securities, which are readily encashable, can lead to an increase in the consumer’s rate of spending.

(e) With the extension of consumers’ credit, such as hire or installment purchase schemes, consumers’ expenditure increases in the economy, adding to inflationary pressures.

An increase in business outlay refers to the increase in investment expenditure by the business community. It expresses an increase in monetary demand for capital goods, raw materials and factors of production.

Business outlay increases considerably when there is a speculative boom, business expectations are optimistic and price rise, that is to say, inflationary symptoms in the economy become substantial by the increased business expenditure, which is profit motivated. Increasing business outlays substantially widen the inflationary gap.

4. Foreign Demand:

As Kurihara points out, “an additional factor in the increased monetary demand is foreign expenditure for domestic goods and services.”

He, however, also points out that the inflationary impact of foreign demand is weakened to the extent that the marginal propensity to import offsets additional expenditures for domestic goods and services out of the increased national income on account of export earnings.

Supply Side:

The inflationary gap is widened when the supply of goods and services does not keep pace with the increased monetary demand for things. The case in the supply of goods and services may be limited on various accounts:

1. Full-employment:

When the full-employment stage is reached by the economy.

2. Shortages:

When there is a shortage and deficiency of factors of production, shortage of land, labour, capital equipment, raw materials, etc. obviously accounts for inadequacy of supply of certain goods.

3. Diminishing Return:

Operating of the law of diminishing returns in variable factors, with a given technological structure, also causes slow movement of supply of real goods and services.

4. Export-Induced Scarcity:

Increasing export of certain goods which have a strong domestic demand evidently aggravates the supply situation.

5. Wage-Price Spiral:

A wage-price spiral is another important factor which aggravates the supply situation. When wages rise, the costs of production also rise. Thus, entrepreneurs usually adjust cost increases by increasing prices rather than by absorbing them, fully or partly, by reducing profits.

When demand is inelastic, businessmen are very much inclined to raise prices, on account of wages, and an increase in wages is demanded because of high prices. Thus, a wage- price spiral is developed, simulating inflation further.