An expansionary (inflationary) gap occurs

Solution

An expansionary or inflationary gap happens when the economy’s actual output (real GDP) is greater than the potential output at full employment. This situation reflects overheating of the economy, where demand exceeds sustainable capacity, creating upward pressure on prices (inflation). For instance, if a country can sustainably produce goods worth $2 trillion but the economy is producing $2.4 trillion, the $0.4 trillion difference is the inflationary gap. Governments usually counter this with contractionary fiscal or monetary policies such as reducing spending or increasing taxes to cool down demand. The opposite is a deflationary gap, where real GDP is below potential GDP, typically associated with unemployment and underutilization of resources.