What is an inflationary gap?

An inflationary gap occurs when actual economic output exceeds the potential output of an economy, indicating that the economy is operating above its sustainable capacity. When this happens, demand outstrips supply, leading to increased pressure on prices, which typically results in inflation.

In this situation, resources such as labor and capital are being utilized beyond their normal capacity, causing upward pressure on wages and prices as companies compete for the limited supply of resources. The economy is essentially overextended, which can lead to imbalances such as inflation if the gap persists.

The other options do not accurately describe an inflationary gap. The difference between government expenditure and revenue refers to a budget deficit or surplus, which is unrelated to output levels. A measure of price stability focuses on keeping inflation low and stable, rather than on the output gap. A situation of falling prices in the economy describes deflation or disinflation, which is the opposite of what occurs in an inflationary gap, where prices generally rise due to excess demand.