If Actual (real) GDP is greater (more than) than potential GDP. then economy will experience a (an)
a. Equilibrium
b. Inflationary Gap
c. Recessionary Gap.
d. Depression
The correct answer and explanation is :
The correct answer is b. Inflationary Gap.
Explanation:
An Inflationary Gap occurs when the Actual GDP (the total value of goods and services produced in an economy) exceeds the Potential GDP (the maximum sustainable output that an economy can produce when it is operating at full capacity without causing inflation). When the economy operates beyond its potential output, there is excessive demand for goods and services relative to what the economy can produce sustainably, leading to inflationary pressures.
Here’s a breakdown of the terms:
- Actual GDP refers to the real output of the economy, i.e., the value of goods and services actually produced within a specific period, typically measured quarterly or annually. This can fluctuate depending on economic conditions.
- Potential GDP refers to the level of economic output that an economy can produce when it is utilizing all its resources efficiently (labor, capital, etc.) without causing inflationary pressures. This level of output assumes that there is no excess demand or underutilized resources.
When Actual GDP exceeds Potential GDP, the economy is said to be operating above its full capacity. This leads to an Inflationary Gap because the demand for goods and services exceeds the economy’s productive capacity. Businesses are pressured to meet the higher demand, often leading to rising prices or inflation. As a result, prices in the economy will generally increase as firms raise prices to manage the imbalance between supply and demand.
Consequences of an Inflationary Gap:
- Increased inflation: Due to higher demand, firms are unable to meet all of it without increasing their prices.
- Potential overheating of the economy: The economy can become “overheated” when it operates beyond its sustainable capacity. This can result in supply bottlenecks, labor shortages, and further inflationary pressures.
- Monetary policy response: Central banks may intervene by increasing interest rates to cool off the economy, slowing down consumer spending and investment, and helping to bring actual GDP back in line with potential GDP.
In contrast:
- Recessionary Gap occurs when actual GDP is below potential GDP, leading to unemployment and underutilization of resources.
- Equilibrium happens when actual GDP equals potential GDP, indicating that the economy is in a stable state of full employment without excessive inflation or recession.
- Depression is a severe and prolonged downturn in economic activity, typically associated with a significant recessionary gap.