An inflationary output gap would generate which of the following conditions in the economy?
The correct answer and explanation is:
The correct answer is: Inflationary pressure.
An inflationary output gap occurs when the actual output of the economy exceeds its potential output. This happens when aggregate demand surpasses aggregate supply at full employment levels. As a result, the economy operates beyond its sustainable capacity, which can generate upward pressure on prices, leading to inflation. Here’s how this works:
When demand in the economy outpaces supply, firms are unable to meet the increasing demand using existing resources efficiently. This mismatch causes firms to raise prices to balance the supply-demand equation. The rise in demand puts pressure on wages and resource costs as firms compete for the limited resources they have available. Consequently, higher production costs lead to cost-push inflation, while higher consumer demand causes demand-pull inflation.
In the short run, as the economy continues to operate above its potential output, inflation accelerates. This happens because the economy is already utilizing resources, such as labor and capital, at full capacity. For instance, workers may demand higher wages as businesses compete for a smaller pool of available labor, which drives up costs. Businesses then pass on these higher costs to consumers in the form of higher prices for goods and services.
Additionally, when the output gap is inflationary, central banks may respond by tightening monetary policy, usually by raising interest rates. This helps cool down the economy by reducing borrowing and spending, which can eventually bring aggregate demand back in line with potential output.
Thus, an inflationary output gap leads to rising prices, increased inflation, and often triggers contractionary policies from policymakers to stabilize the economy.