explain inflationary gap with the help of diagram
Due to the excess of aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as inflationary gap. This gap measures the amount of surplus in the level of aggregate demand. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF). Inthe figure,EYdenotes the aggregate demand at the full employment level of output andFYdenotes the actual aggregate demand. The vertical distance between these two represents inflationary gap. That is,
FYEY=FE (Inflationary Gap)
Let us understand the situation of excess demand and concept of inflationary gap with the help of the following figure.
In the figure,AD1and AS represents the aggregate demand curve and aggregate supply curve respectively. The economy is at full employment equilibrium at point E, whereAD1intersectsAScurve. At this equilibrium point,OYrepresents full employment level andEYis aggregate demand at the full employment level of output.
Let us suppose that the actual aggregate demand for output isFY, which is higher thanEY. This implies that actual aggregate output demanded by the economyFYis more than the potential (full employment) aggregate outputEY. Thus, the economy is facing surplus demand. This situation is termed as excess demand. As a result of the excess demand, inflationary gap arises. The inflationary gap is measured by the vertical distance between the actual aggregate demand for output and the potential (or full employment level) aggregate demand. In other words, the distance betweenFYandEY, i.e.FErepresents the inflationary gap.
This gap is termed as inflationary gap because the excess aggregate demand will merely resultin increase in the price, without affecting the output level. The rise in the price is due to the fact that the economy is already operating at full employment level of equilibrium and output cannot be increased further. Therefore, an excess demand will lead to an increase in price. Such increase in price, which is due to excess demand, is termed asdemand-pull inflation. It should be noted that the rise in the price leads to a rise in the nominal value of output only, while the real value of output remains the same.