An inflationary gap occurs when an economy’s total demand is higher than its maximum sustainable capacity. This means the actual national income is greater than the full employment level, leading to rising prices.

Key features:

• It is a type of positive output gap, where actual output is greater than potential output.
• When total demand exceeds the supply capacity, firms face supply constraints. Because they cannot produce more, they increase prices.
• This process causes demand-pull inflation.
• On an AD-AS diagram, it is the distance between the actual equilibrium and the point where output reaches its limit (the vertical part of the supply curve).
• To fix this, governments often use contractionary fiscal policy (spending less or raising taxes) or central banks use contractionary monetary policy (raising interest rates).
• The multiplier effect means the government must be careful about how much they reduce spending to close the gap.