Inflationary gap


An increase in aggregate demand due to factors like loose monetary policy, or a real-estate boom.  This results in higher prices, and a level of GDP greater than full-employment GDP in the short run. We call this an inflationary gap. The economy can operate at this level in the short run, as workers work overtime and maintenance of productive equipment is delayed. 

However, this is unsustainable  in the long run. This is because wages and input prices increase under intense competition, thus increasing costs of production, shifting the SRAS curve to the left.  So in the long run, the economy goes back to full-employment GDP, but at a price level that is higher than before. This is undesirable as price levels go up without any increase in real output.  If left unchecked, this can result in an inflationary loop where prices keep going up.

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