Page 202 - DECO402_Macro Economics

Unit-22: Inflation

22.3 Inflationary Gap Notes

Demand pull inflation of Keynes may be present as inflationary gap. It is related to excess of demand
as compared to available production, at full employment level. If at the level of present prices, sufficient
goods are available, then this gap will end.
Inflationary gap has been explained in figure 22.3. In this figure axis X shows gross national product
or income of the economy. Axis Y represents total expense included in consumption expense (C),
private investment expense (I) and in government expense (G). In the figure, economy is in balance
at point E, where total supply of goods and services (OY income) is equal to their demand reflected
f
by total expense (C + I + G). The C + I + G curve intersects the 45° line at point E. It also pictures
full employment income at Present pre-inflation prices. At this level of income, there is no excess
demand.
Now assume that due to government expense
increasing equivalent to the amount EA for
reasons like war or development, demand curve
moves up. New collective expense increase up
to C + I + G’, as a result of which there is an
excess demand of EA, equivalent to amount of Collective Expenditure
increase in government expense. Since economy
would be working on full employment, hence
this excess demand of EA cannot be erased.
This gap between the collective demand and
available supply is called inflationary gap which
moves the prices up. New collective expense is Income
AY whereas national income at present prices Figure 22.3
f
is OY . Monetary demand for OY production is
f
f
not EY , but AY . Here EA is inflationary gap, which is found because in comparison to production of
f
f
goods or services, expense increases at a faster speed. Hence, at a high price level, for making expense
equal to money of production, prices increase. Unless amount of disposable income with the people
is more that the amount of goods (kept) with them, inflationary gap will surface.
Inflationary gap emerges because of the extra expense by the government. During the war or during
the period of economic development, reduction in government expense is not necessary for reducing
inflationary gap. Inflationary gap may be met (like this):
(i) For reducing effective demand, wilful increase in savings by the society.
(ii) For reducing C + I by amount equal to increase in government expense, by using tax methods
excess purchasing power with people may be wiped off.
(iii) Increasing the production of goods and services for meeting excess demand; though because
of lack of unused resources, there is little scope here.

22.4 Effects of Inflation

Most economists have the opinion that slow inflation is not only required but also an important
condition for economic development. It is especially true for undeveloped countries like India, where
human power is unemployed. And provides support in consolidating other resources, which will
otherwise not be available. When inflation runs fast and takes the form of hyper inflation, entire
economy is disturbed. In such condition, planning process is disturbed and process of economic
development may stop. Effects of inflation may be studied under three heads:

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