Definition
An inflationary gap exists when an economy's actual output rises above its potential output — the sustainable level it can produce when labor and capital are fully but not overstretched. In this state, demand outruns what the economy can comfortably supply.
It is the opposite of a recessionary gap, where output falls short of potential and resources sit idle. The inflationary gap signals an economy running hot, with the telltale symptom being accelerating prices.
Why it matters
How it works
When aggregate demand pushes spending beyond potential output, firms cannot expand real production fast enough, so they bid up wages to attract scarce workers and raise prices to ration limited goods. The result is inflation rather than more output. Policymakers respond with contractionary measures — central banks raise interest rates, governments may trim spending — to cool demand back toward potential. The challenge is judgment and timing: potential output cannot be measured precisely, so closing the gap too aggressively risks tipping the economy into a downturn, while acting too slowly lets inflation build momentum.