Inflation gap

Inflation gap is an important concept in fiscal policy. With an inflation gap means that GDP is higher than it should be at full employment in the economy.

An inflation gap means that the prices in the economy are higher than they should be. An inflation gap shows how much demand must decrease so that inflation will reach an acceptable level. Fiscal policy should try to reduce the inflation gap to reach the goal of a stable price levels. The government can reduce public expenditures that constitute endogenous (not dependent of GDP) contribution to the economic circulation.

A reduction in government spending generates multiplier effects, which means that demand is decreasing more than the public expenditure reduction. The government may also raise taxes to reduce demand in the economy, taxes are exogenous (depending of GDP) leakage. A tax increase will reduce the multiplier effects in the economy.