What Is an Inflationary Gap?

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DEFINITION
An inflationary gap is the difference in what gross domestic product (GDP) would be under full employment and the actual reported GDP number.

An inflationary gap is the difference in what gross domestic product (GDP) would be under full employment and the actual reported GDP number. It is the increase in real GDP that causes inflation, and the inflationary gap is used to assess and quantify the pressure of inflation.

Economists look at inflationary gaps as a way to understand how inflation leads to increased output. This helps evaluate the magnitude and effects of inflation, which may be good for some industries and individuals, and harmful for others. Usually, inflation is associated with high employment, so the number of people working is the starting point for the analysis.

Definition and Example of Inflationary Gap

An inflationary gap occurs when the economy is operating above full employment. It represents the extra output as measured by GDP between what it would be under the natural rate of unemployment and the reported GDP number. Think of it as the rise in GDP driven by inflation.

  • Alternate name: expansionary gap

Here’s an example. Suppose at full employment without inflation, the people in an economy demand 500,000 sweaters a year. Inflation occurs, then wages increase, so people now have more income. They demand 550,000 sweaters a year. The increase of 50,000 sweaters represents an inflationary gap.

The increase in demand leads to new revenue and higher materials prices for the sweater makers—if they can meet the increase in demand profitably. If they can’t, then the gap represents lost sales.

How Does an Inflationary Gap Work?

When inflation leads to higher wages, and higher wages lead to increased consumer demand, an inflationary gap is created. It is based on two economic concepts: the non-accelerating inflation rate of employment, also called NAIRU or the short-term natural rate of unemployment, and potential GDP, a theoretical estimate of the value of the output that the economy would have produced if labor and capital had been employed at their maximum rates. The idea is that there is a trade-off between inflation and employment, which economists call the Phillips curve.

The natural rate of unemployment allows for occurrences such as new graduates entering the workforce, people who are fired for non-performance, and businesses that fail due to bad management.

If there is an increased demand for labor, employers will have to increase wages to attract workers, and employment levels may go above the natural rate. When that happens, the rate of inflation may accelerate. One way to look at the effects of that inflation is to assess the inflationary gap.

An inflationary gap is an increase in demand for goods and services caused by a heightened demand for labor.

Some of these concepts are debatable. Academic economists write papers all the time about the level of the natural rate of unemployment and the existence of potential GDP. If you can’t calculate a natural rate of unemployment, then you can’t calculate an inflationary gap.

Economies are dynamic, and many of these concepts assume that they are static. That’s not bad for analysis, but it can be confusing if you are not an economist and just want to understand what is going on.

For non-economists, it’s enough to know that inflation can be driven by demand for workers because employers will need to increase wages to attract them. Because these workers will make more money, that will boost their demand for goods.

What It Means for Individual Investors

An inflationary gap indicates two things. First, demand for labor is going up. Second, this is leading to increased demand for goods and services. With that, investors can figure out which factors affect various investments.

Industries that are labor-intensive and have trouble with worker turnover in normal economies will be under pressure in a period of inflationary employment.

For example, food service is typically difficult, entry-level work that relies on a large number of people to do it. As demand for all workers increases, people will opt for jobs other than food service, even as people with increased wages demand more restaurant meals. Revenue for restaurants may increase—if there are enough workers—but costs will increase, too. If a restaurant can’t find enough workers paid at a profitable wage, it can’t take advantage of the elevated demand. The expansionary gap represents a loss in that case.

Businesses you may be considering investing in that are not labor-intensive may benefit from an inflationary gap because they can earn more revenue without increasing costs. For example, highly automated manufacturing operations may experience increased profits because they can produce enough to meet demand without a proportionate increase in costs. If they can produce the goods to meet the heightened demand, they will see their revenue and profits grow.

Likewise, software and technology companies often have lean staffing, which can help take advantage of an inflationary gap.

Investors will want to look at their holdings to see where expansionary gaps will boost profits and where they could be destructive. A company that can generate more sales without adding workers will do better than one that needs more workers to bring in the bucks.

Key Takeaways

  • Inflationary gaps occur when increased demand for labor leads to higher wages, which in turn lead to increased demand for goods and services.
  • Often called an expansionary gap, it is the difference between the amount of goods demanded now and the amount that would be demanded under a normal level of employment.
  • The more a business relies on labor, the more it will be hurt by an inflationary gap.

Article Sources

  1. Federal Reserve Bank of St. Louis. “The NAIRU: Tailor-Made for the Fed?” Accessed Feb 3, 2022.

  2. Brookings Institution. “What Is Potential GDP, and Why Is It So Controversial Right Now?” Accessed Feb. 3, 2022.

  3. Federal Reserve Bank of St. Louis. “What’s the Phillips Curve (and Why Has It Flattened)?” Accessed Feb. 3, 2022.