Solutions That Can Help Manage an Inflationary Gap

The inflation gap represents a variance between the real Gross Domestic Product (GDP) and the projected GDP at full employment.

According to the International Monetary Fund (IMF), the inflation rate in 2023 is expected to remain high at 6.6%. Since inflation has been a global concern for many years, this write-up will discuss the measures that can be taken to manage an inflationary gap. Let’s start by understanding what causes inflation.

The Causes of Inflation?

Various elements can affect price surges in the economy. Two major drivers bear the greatest impact on the inflation rate; increased demand and input prices. In addition to the two, other factors that can cause inflation include;

1. Devaluation: This is a government effort to reduce a country’s currency. Devaluation is usually executed to minimize export costs.
2. Loans via government bonds: The government receives bonds from the Federal Reserve to support its spending and obligations, injecting a new currency stream into the market. This strategy magnifies the buying power that can also develop significant fall out.

Two forms of inflation can be derived from the two major causes; cost-push and demand-pull inflation.

1. Cost-Push Inflation

The supply and demand levels are the primary determinants of prices for goods and services in a free market economy. When the demand or supply changes, there is an automatic price difference.

The production cost is the key factor that influences cost-push inflation. When businesses spend more to produce goods and services, the aggregate supply in the economy reduces. The producers will transfer the production costs to consumers, which can lead to increased prices.

1. Demand-Pull Inflation

This inflation type occurs when the demand for goods and services rises. When the demand for commodities and services exceeds the market supply, there is a price hike. This inflation happens when the economy is growing seamlessly.

What Causes Inflationary Gap?

An inflationary gap refers to the difference between the real gross domestic product (GDP) at full employment and the actual GDP. Several conditions can cause the inflationary gap, including a significant unemployment rate, expanded trading activities, and very high government expenditure.

How to Manage an Inflationary Gap?

Various approaches have been used to manage the inflationary gap. Although none of these methods have proven 100% effective in achieving the desired results, some strategies have been more effective in controlling inflationary gaps than others. The following are some of the strategies that can be used to manage an inflationary gap.

1. Price Controls

The government can provide price caps to control the prices of certain goods. In 1971, US President Richard Nixon used price controls to manage the inflation rate. Though the measures were initially popular in controlling inflation, they failed to control it in 1973 when it skyrocketed after World War II. Most economists think price control may be less effective during high inflation.

1. Monetary Policy

This is a government policy that is aimed at reducing government spending. Besides, it helps lower the rate of currency expansion in fighting inflation. Monetary policy intervention can help raise interest rates to lower the monetary supply in an economy.

The overall goal of contractionary monetary policy is to slow economic growth by making access to credit more expensive to reduce the expenditures of consumers and businesses.

1. Control of Supply of Money

Economists argue that there is a correlation between currency supply and inflation. When monetary supply is controlled, inflation is managed. Central banks focus on the following fiscal strategies to control the money supply

1. Increasing interest rates
2. Reducing budget deficits
3. Controlling money produced by the government

4. Wage Control

High inflation has led to labor unions to fighting for higher wages for their workers. Activists have also been influencing government policy changes to increase minimum wages in response to rising inflation. Wage control policies can be a significant effort to cushion low-income workers during high inflation.

1. Exchange Rate Policy

A government can maintain lower inflation rates if it comes up with a fixed exchange rate program. When the value of a currency is stable, it lowers the inflation rate. The downside of this approach is that it can be more difficult to control inflation.

1. Changing Currency

During the hyperinflation period, traditional methods of controlling inflation can be ineffective. People may also lose confidence in their currency if it is adversely affected by high inflation. In addressing hyperinflation, there is a need to introduce a new currency in the market.

1. Supply-Side Policies

Rising costs of living characterize periods of high inflation. Policies designed to control the supply of commodities can enhance the economy’s stability, thus moderating inflation pressures. However, this kind of inflation control can take longer to realize its impact and can’t address inflation related to high demand.

Final Thoughts

Inflation has been a global concern, with its impacts greatly felt by low-income earners. The cost of living is significantly high, necessitating immediate measures by governments worldwide to take a leading role in addressing the high inflation levels to cushion citizens from unbearable lifestyles.