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    Question

    An expansionary (inflationary) gap occurs

    when:
    A Actual real GDP exceeds the full-employment level of real GDP Correct Answer Incorrect Answer
    B Actual real GDP falls short of the full-employment level of real GDP Correct Answer Incorrect Answer
    C Actual real GDP equals potential real GDP Correct Answer Incorrect Answer
    D Nominal GDP exceeds real GDP Correct Answer Incorrect Answer
    E Aggregate demand is equal to aggregate supply at full employment Correct Answer Incorrect Answer

    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.

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