In this article we will discuss about:- 1. Concept of Inflationary Gap 2. Criticisms of Inflationary Gap 3. Importance.
Concept of Inflationary Gap:
In his pamphlet, “How to Pay for the War” published in 1940, Keynes explained the concept of the inflationary gap. It differs from his views on inflation given in the General Theory. In the General Theory, he started with underemployment equilibrium. But in How to Pay for the War, he began with a situation of full employment in the economy.
He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey, “The inflationary gap is the amount by which aggregate expenditure would exceed aggregate output at the full employment level of income.”
The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment. Keynes, on the other hand, ascribed it to the excess of expenditure over income at the full employment level.
The larger the aggregate expenditure, the larger the gap and the more rapid the inflation. Given a constant average propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes used the concept of the inflationary gap to show the main determinants that cause an inflationary rise of prices.
The inflationary gap is explained with the help of the following example:
Suppose the gross national product at pre-inflation prices is Rs.200crores. Of this Rs.80crores is spent by the Government. Thus Rs.120 (Rs.200-80) crores worth of output is available to the public for consumption at pre-inflation prices. But the gross national income at current prices at full employment level is Rs.250crores. Suppose the government taxes away Rs.60crores, leaving Rs.190crores as disposable income. Thus Rs.190crores is the amount to be spent on the available output worth Rs.120crores. thereby creating an inflationary gap of Rs.70crores.
This inflationary gap model is illustrated as under:
In reality, the entire disposable income of Rs.190Crores is not spent and a part of it is saved. If, say, 20 per cent (Rs.38croes) of it is saved, then Rs.152crores (Rs.190-Rs. 38crores) would be left to create demand for goods worth Rs.120crores. Thus the actual inflationary gap would be Rs.32 (Rs.152-120) crores instead of Rs. 70crores.
The inflationary gap is shown diagrammatically in Figure 2 where YF is the full employment level of income, 45Â° line represents aggregate supply AS and C+1+G line the desired level of consumption, investment and government expenditure (or aggregate demand curve). The economy’s aggregate demand curve (C+1+G) = AD intersects the 45 per cent line (As) at point E at the income level OY1 which is greater than the full employment income level OYF.
The amount by which aggregate demand (YFA) exceeds the aggregate supply (YFB) at the full employment income level is the inflationary gap. This is AB in the figure. The excess volume of total pending when resources are fully employed creates inflationary pressures. Thus the inflationary gap leads to inflationary pressures, in the economy which are the result of excess aggregate demand.
How can the inflationary gap be wiped out?
The inflationary gap can be wiped out by increase in savings so that the aggregate demand is reduced. But this may lead to deflationary tendencies. Another solution is a raise the value of available output to match the disposable income.
As aggregate demand increases, businessmen hire more labour to expand output. But there being full employment at the current money wage, they offer higher money wages to induce more workers to work for them. As there is already full employment, the increase in money wages leads to proportionate rise in prices.
Moreover, output cannot be increased during the short run because factors are already fully employed. So the inflationary gap can he closed by increasing taxes and reducing expenditure. Monetary policy can also be used to decrease the money stock. But Keynes was not in favour of monetary measures to control inflationary pressures within the economy.
Criticisms of Inflationary Gap:
The concept of inflationary gap has been criticised by Friedman, Koopmans, Salant, and other economists.
1. The analysis of inflationary gap is based on the assumption that full employment prices are flexible upward. In other words, they respond to excess demand in the market for goods. It also assumes that money wages are sticky when prices are rising, but the share of profits in GNP increases. So this concept is related to excess-demand inflation in which there is profit inflation. This has led to the mixing up of demand and cost inflations.
2. Bent Hansen criticizes Keynes for confining the inflationary gap to the goods market only and neglecting the role of the factor market. According to him, an inflationary gap is the result of excess demand in the goods market as well as in the factor market.”
3. The inflationary gap is a static analysis. But the inflationary phenomena are dynamic. To make them dynamic, Keynes himself suggested the introduction of time lags concerning receipts and expenditures of income. Koopmans has developed relationships between eggs and the rate of price increase per unit of time. He has shown with the help of spending lags and wage-adjustment lags that the speed of inflation becomes smaller, that is the inflationary gap is narrowed.
4. Holzman has criticised Keynes for applying the multiplier technique to a full employment situation. According to him, the multiplier technique is not adequate in periods of full employment and inflation. It abstracts from changes in the distribution of income. In a full employment situation, the share of one group in the national output can only be increased at the expense of another.
5. Another weakness of the inflationary-gap analysis is that it is related to flow concepts, such as current income, expenditure, consumption, and saving. In fact, the increase in prices at the full employment level is not confined to prices of current goods alone. But they also affect the prices of goods already produced. Further, the disposable income which is the difference between current income and taxes, may include idle balances from the income of previous periods.
Importance of Inflationary Gap:
Despite these criticisms the concept of inflationary gap has proved to be of much importance in explaining rising prices at full employment level and policy measures in controlling inflation. It tells that the rise in prices, once the level of full employment is attained, is due to excess demand generated by increased expenditures.
But the output cannot be increased because all resources are fully employed in the economy. This leads to inflation. The larger the expenditure, the larger the gap and more rapid the inflation.
As a policy measure, it suggests reduction in aggregate demand to control inflation. For this, the best course is to have a surplus budget by raising taxes. It also favours saving incentives to reduce consumption expenditure.
“The analysis of the inflationary gap in terms of such aggregate as national income, investment outlays and consumption expenditures clearly reveals what determines public policy with respect to taxes, public expenditures, savings campaigns, credit control, wage adjustmentâ€”in short, all the conceivable anti- inflationary measures affecting the propensities to consume, to save and to invest which together determine the general price level.”