What is indicated by an inflationary gap?

An inflationary gap occurs when the actual aggregate output in an economy exceeds its potential output. Potential output is defined as the maximum sustainable output that an economy can produce without generating inflationary pressures. When aggregate output is above this level, it typically indicates that resources are being utilized beyond their normal capacity, which can lead to higher prices as demand outstrips supply.

In such a scenario, businesses may face increased costs due to higher demand for labor and materials, pushing up prices and contributing to inflation. This situation often arises during periods of economic expansion, where increased consumer spending and investment drive output beyond what the economy can sustain in the long run.

Understanding this concept helps to clarify the dynamics of inflation and economic cycles, highlighting the balance needed to maintain stable prices while promoting growth.