Saturday, August 22, 2009

Keynesian Theory of Inflationary Gap

In his pamphlet “How to pay for the war” Keynes explained the concept of the inflationary gap. It differs from his views on inflation given in the “General Theory”. In the “General Theory” he started with unemployment equilibrium. But in “How to pay for War” he began with situation of full employment in the economy. He defined an inflationary gap as an excess of planned expenditure over the available output at pre-inflation or base prices. According to Lipsey “The inflationary gap is amount by which aggregate expenditure would exceed aggregate output at the full employment level of income”. The classical economists explained inflation as mainly due to increase in the quantity of money, given the level of full employment. Keynes on the other hand ascribed it to the excess of expenditure over income at the full employment level. The larger the aggregate expenditure the large the gap and the more rapid the inflation. Given a constant average propensity to save, rising money incomes at full employment level would lead to an excess of demand over supply and to a consequent inflationary gap. Thus Keynes ased the concept of the inflationary gap to show the main determinant that cause an inflationary rise of prices.
Inflationary gap arises when consumption and investment spending together are greater than full employment GNP level. This means that people are demanding more goods and services that can be produced. In other words, the implications of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased demand for goods and services on the part of the people will be to raise the price level. Or we may say that there will e an inflationary gap, if scheduled investment tends to be greater than full employment saving. In situation like this more goods will be demanded than the economic system can produce. The result will be that the prices will begin to rise and an inflationary situation will emerge. Thus if full employment saving falls short of scheduled investment at full employment (which means people’s propensity to spend is higher than the propensity to save) there will an inflationary gap.
HOW CAN THE INFLATIONARY GAP BE ELIMINATED
The inflationary gap can be wiped out by increase in savings so that the aggregate demand is reduced. But this may lead to deflationary tendencies.
Another solution is to raise the value of available output to match the disposable income. As aggregate demand increases, businessmen hire more labour to expand output. But there being full employment at the current money wage, they offer higher money wages to induce more workers to work for them. As there is already full employment, the increase in money wages leads proportionate rise in prices. More over output cannot be increased during the short run because factors are already fully employed. So the inflationary gap can be closed by increasing taxes and reducing expenditure. Monetary policy can also be used to decrease the money stock. But Keynes was not in favour of monetary measures to control inflationary pressure within economy.

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