Inflationary Gap

In his pamphlet,’ how to pay for the war ‘published in 1940, Keynes explained the concept of ‘inflationary gap’. It differs from his views on inflation given in the general theory. In the general theory, he started with underemployment equilibrium, but in how to pay for the war, he began with a 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 the 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 larger the gap and the more rapid the inflation will increase. 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 used the concept of the inflationary gap to show the main determinants that cause an inflationary rise in prices.

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