What Is an Inflationary Gap?

Definition and Example of Inflationary Gap

An inflationary gap occurs when the economy is operating above full employment. It represents the extra output as measured by GDP between what it would be under the natural rate of unemployment and the reported GDP number. Think of it as the rise in GDP driven by inflation.

• Alternate name: expansionary gap

Here’s an example. Suppose at full employment without inflation, the people in an economy demand 500,000 sweaters a year. Inflation occurs, then wages increase, so people now have more income. They demand 550,000 sweaters a year. The increase of 50,000 sweaters represents an inflationary gap.

The increase in demand leads to new revenue and higher materials prices for the sweater makers—if they can meet the increase in demand profitably. If they can’t, then the gap represents lost sales.

How Does an Inflationary Gap Work?

When inflation leads to higher wages, and higher wages lead to increased consumer demand, an inflationary gap is created. It is based on two economic concepts: the non-accelerating inflation rate of employment, also called NAIRU or the short-term natural rate of unemployment, and potential GDP, a theoretical estimate of the value of the output that the economy would have produced if labor and capital had been employed at their maximum rates. The idea is that there is a trade-off between inflation and employment, which economists call the Phillips curve.

The natural rate of unemployment allows for occurrences such as new graduates entering the workforce, people who are fired for non-performance, and businesses that fail due to bad management.

If there is an increased demand for labor, employers will have to increase wages to attract workers, and employment levels may go above the natural rate. When that happens, the rate of inflation may accelerate. One way to look at the effects of that inflation is to assess the inflationary gap.

Some of these concepts are debatable. Academic economists write papers all the time about the level of the natural rate of unemployment and the existence of potential GDP. If you can’t calculate a natural rate of unemployment, then you can’t calculate an inflationary gap.

Economies are dynamic, and many of these concepts assume that they are static. That’s not bad for analysis, but it can be confusing if you are not an economist and just want to understand what is going on.

For non-economists, it’s enough to know that inflation can be driven by demand for workers because employers will need to increase wages to attract them. Because these workers will make more money, that will boost their demand for goods.

What It Means for Individual Investors

An inflationary gap indicates two things. First, demand for labor is going up. Second, this is leading to increased demand for goods and services. With that, investors can figure out which factors affect various investments.

For example, food service is typically difficult, entry-level work that relies on a large number of people to do it. As demand for all workers increases, people will opt for jobs other than food service, even as people with increased wages demand more restaurant meals. Revenue for restaurants may increase—if there are enough workers—but costs will increase, too. If a restaurant can’t find enough workers paid at a profitable wage, it can’t take advantage of the elevated demand. The expansionary gap represents a loss in that case.

Businesses you may be considering investing in that are not labor-intensive may benefit from an inflationary gap because they can earn more revenue without increasing costs. For example, highly automated manufacturing operations may experience increased profits because they can produce enough to meet demand without a proportionate increase in costs. If they can produce the goods to meet the heightened demand, they will see their revenue and profits grow.

Likewise, software and technology companies often have lean staffing, which can help take advantage of an inflationary gap.

Investors will want to look at their holdings to see where expansionary gaps will boost profits and where they could be destructive. A company that can generate more sales without adding workers will do better than one that needs more workers to bring in the bucks.