Q. 205.0( 1 Vote )

What is meant by

Answer :

The concept of an inflationary gap was introduced by J M Keynes. The inflationary gap is the gap between the actual output and the potential output in the economy. It is the difference between the actual output and the planned expenditure during a period of time in the economy. The actual output is determined by the employment and the level of technical progress. The planned expenditure is determined by the level of savings and taxation in the system.


The inflationary gap or the expansion gap determines the difference between the actual output and the potential output.



In the following diagram, the level of income in the economy is Y0 at the point of intersection of the C+I and the C+S curves. The equilibrium point at Y0 level of income is E0. When the total investment expenditure in the economy increases, the consumption curve shifts upwards and forms the C+I’ curve. The equilibrium point will be E1 with the equilibrium income being Y1 at the intersection of the C+S curve and the C+I’ curve.


At this point, the actual output in the economy is E0Y0, while the actual expenditure is E1Y1. This difference between the actual and the potential output is the inflationary gap. It is equal to E2E0. This results in inflationary rising prices in the economy. The steps for avoiding the inflationary gap are:


Voluntary savings: This is the most important step that can be taken to reduce the inflationary gap in the economy. The voluntary savings by the public helps to reduce the circulation of credit in the economy. This reduces the level of spending.


Increase the total output: This can be done only by raising the productive capacity of the labour force or improvements in the level of technology. When the total output is increased according to the increase in expenditure, the stock would be sufficient to meet the needs of the public thus reducing the gap between the actual and the potential output.


Increase tax rate: An increased tax rate reduces the total disposable income available with the people. This, in turn, reduces their demand for goods and services. Thus the reduction in demand reduces the total spending in the economy.


Reducing government expenditure: An reduced government expenditure decreases the total disposable income available with the people. This, in turn, reduces their demand for goods and services. Thus the reduction in demand reduces the total spending in the economy.


OR


Aggregate demand is the total demand for goods and services in the economy at a given point in time. It is the sum total of the demand for the actual output in the economy by each sectors operating within the economy. It represents the total demand for the goods and services produced and consumed in the economy. The various components of aggregate demand are:


Consumption demand: The consumption expenditure and thus the consumer demand is the largest component of aggregate demand. The level of consumption is determined by the level of income. According to Keynes, as income increases consumption also increases, but less than proportionately. Thus, consumption is an increasing function of income.


Investment demand: Investment refers to the amount spent in the economy to augment the existing capital stock and creating additional resources in the economy. It is the second important component of the aggregate demand function. The rate of investment in the economy is determined by the rate of interest and business expectations in the future.


Government expenditure: This is the third important component in the aggregate demand function. Since the modern governments are welfare oriented, the government investment is not determined by the rate of interest or the expected risk and return from it. It is not also related to the level of income. In most cases, the government expenditure is autonomous in nature.


The aggregate demand function in a closed economy can be represented by the following equation:


Y=C+I+G


Net exports: In the modern economies, the foreign sector also has a very important role to play in the economic systems. The role of the foreign sector is represented by the net exports. Net exports are the difference between exports and imports. This also plays an important role in aggregate demand determination.


The aggregate demand function in a closed economy can be represented by the following equation:


Y=C+I+G+(X-M)


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