Name: Inflationary Gap in India: Causes and Consequences
Uploaded: 2026-02-02
Duration: 8 min 22 s
Description: MCom Part I - Economics Viva. Inflationary Gap in India.

MCom Part I - Economics Viva. Inflationary Gap in India. 

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Introduction to Inflationary Gap. Understanding the Keynesian Perspective. 

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An inflationary gap (also called expansionary gap) is the positive difference between an economy's actual real GDP and its potential GDP at full employment.

First established by John Maynard Keynes to assess and quantify inflation pressure. It arises during the expansionary phase of the business cycle.

Occurs when aggregate demand exceeds aggregate supply at full employment level, creating upward pressure on prices.

Demand for goods & services exceeds production capacity at full employment

Higher demand pulls prices upward as supply cannot increase beyond potential output

Economy operates at or near full employment with no idle resources

Typically occurs during economic boom or expansionary periods

Theoretical Framework: AD-AS Model. Understanding Aggregate Demand and Aggregate Supply. 

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Understanding Aggregate Demand and Aggregate Supply

Total demand for goods and services in an economy at a given price level.

Total output firms are willing to produce at different price levels.

Short Run: Upward sloping - firms increase supply with higher prices

Long Run: Vertical at potential GDP - determined by resources, not prices

Inflationary Gap Diagram (Keynesian Cross)

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Explanation: At full employment output (Yf), aggregate demand AD' exceeds the 45° line by distance AB. This vertical distance AB represents the inflationary gap - the excess demand that pulls up prices without increasing output.

Inflationary Gap in Indian Context. Meaning and Relevance for the Indian Economy. 

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Meaning and Relevance for the Indian Economy

In India, inflationary gap occurs when the growing aggregate demand (driven by rising incomes, government spending, and credit expansion) exceeds the economy's productive capacity at full employment.

India's rapidly growing economy with a large population often faces this challenge as demand outpaces supply, particularly in food and essential commodities.

India faces the dual challenge of maintaining high growth rates while controlling inflation. The government and RBI must balance expansionary policies for growth with contractionary measures to prevent overheating.

RBI Target: 4% ± 2% (2% to 6% tolerance band)

Food inflation: Vegetables & pulses (32.3% contribution)

Core inflation: Decreased by 0.9 percentage points

Fuel inflation: Significant decline observed

Rural vs Urban: Rural at 5.76%, Urban at 4.58%

Recent Trend: Retail inflation has moderated from 5.4% in FY24 to 4.9% in FY25 (Apr-Dec), showing effective policy coordination between RBI and Government.

Major Causes of Inflationary Gap in India. Demand-Pull Factors and Supply-Side Constraints. 

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Major Causes of Inflationary Gap in India

Demand-Pull Factors and Supply-Side Constraints

High public spending on infrastructure, welfare schemes, and development projects increases aggregate demand. Fiscal deficit at ~5.1% of GDP (FY24).

RBI's accommodative monetary policy and increased bank credit to agriculture, industry, and housing sectors boost purchasing power.

Growth in per capita income (9.5% annually over last decade) increases consumer demand for goods and services.

Repo rate at 6.5% (after 100 bps cut in 2025) encourages borrowing and spending, stimulating demand.

Weather disruptions, inadequate storage, and supply chain inefficiencies limit food production. Extreme weather affects vegetable production significantly.

Poor transportation networks and logistics increase costs and delays, constraining supply response to demand.

Cyclones, floods, droughts, and unseasonal rains cause temporary supply disruptions, especially in perishables like tomatoes and onions.

Import dependence for oil and certain commodities exposes India to international price shocks and supply chain disruptions.

Consequences of Inflationary Gap. Impact on Economy, Prices, and Society. 

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When inflation exceeds wage growth, real purchasing power declines. Global real wages dropped 0.9% in H1 2022.

Households need more income to afford the same quantity of goods and services.

Rural households spend 58% of income on food (up from 52% in 2011-12).

Lower-income groups spend higher proportion of income on essentials, making inflation more burdensome.

Rural areas face higher food inflation (6.8% avg), while urban areas struggle with housing costs (6.1% avg).

Daily wage laborers and informal sector workers are particularly affected as their earnings don't adjust quickly.

Impact on Savings, Investment & Stability

Higher expenditure on essentials leaves less room for savings, affecting capital formation.

Inflation creates uncertainty, discouraging long-term investment planning by businesses.

Workers demand higher wages → production costs rise → prices increase further → vicious cycle .

Key Statistic: Real per capita income grew at 4.6% annually (2012-2024), but real household consumption grew only 3.3%, showing inflation's dampening effect.

Long-term Concern: Persistent inflationary gap can lead to macroeconomic instability, currency depreciation, and erosion of international competitiveness.

Role of Government and RBI. Control Measures: Monetary and Fiscal Policies. 

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Control Measures: Monetary and Fiscal Policies

RBI targets CPI inflation at 4% with ±2% tolerance band (2% to 6% range) under the Monetary Policy Framework Agreement.

Repo rate maintained at 6.5% . RBI raised rates by 250 bps (4% to 6.5%) between May 2022-Feb 2023, then cut 100 bps in 2025.

CRR cut by 50 bps to 4.00% (Dec 2024), adding ₹1.16 lakh crore liquidity to banking system.

RBI conducts OMOs to manage liquidity and control money supply in the economy.

Government committed to reducing fiscal deficit from 9.5% (2020) to 5.1% (2024) , aiming for sustainable levels.

Strengthening buffer stocks for essential food items and strategic releases through Open Market Sales .

Facilitating imports during supply shortages, imposing export curbs, and implementing stock limits on select commodities.

Free food grains to 81 crore beneficiaries under National Food Security Act; Bharat brand retail sales at subsidized rates.

Policy Coordination: Effective control of inflationary gap requires coordinated action from both RBI (monetary policy) and Government (fiscal policy). Recent success in reducing inflation from 5.4% to 4.9% demonstrates this coordination.

Recent Examples and Relevance. Current Trends and Real-World Applications. 

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Current Trends and Real-World Applications

Retail inflation has declined from 5.4% in FY24 to 4.9% in FY25 (Apr-Dec), aided by government initiatives and monetary policy measures. Core inflation decreased by 0.9 percentage points.

Vegetables & Pulses: Contribute 32.3% to overall inflation (FY25 Apr-Dec)

Extreme Weather: Cyclones, floods, droughts impact production and prices

Supply Chain: Storage and transportation challenges cause temporary disruptions

Onion & Tomato: Price volatility due to perishable nature and concentrated production

RBI and IMF project India's CPI inflation to align towards 4% target in FY26 :

Policy Success: Coordinated monetary and fiscal measures have successfully reduced inflation from 5.4% to 4.9%, demonstrating effective management of inflationary pressures. Global commodity prices expected to decline 5.1% in 2025, positive for India's inflation outlook.

Conclusion. Key Findings and Summary. Key Findings. 

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Inflationary gap is a Keynesian concept where aggregate demand exceeds aggregate supply at full employment, creating upward price pressure.

India faces both demand-pull factors (fiscal deficit ~5% GDP, credit expansion) and supply-side constraints (weather, infrastructure gaps).

Consequences include purchasing power erosion , regressive income effects (hurting poor more), and reduced savings/investment.

RBI's monetary policy (inflation targeting, repo rate at 6.5%) and Government's fiscal measures (buffer stocks, fiscal consolidation) work together.

Inflation declined from 5.4% to 4.9% , within RBI's target band, demonstrating effective policy coordination.

Need to balance growth aspirations with price stability - a delicate but achievable equilibrium through coordinated policies.

The inflationary gap framework provides a valuable tool for understanding and managing inflation in India. While challenges persist, particularly in food inflation, the coordinated efforts of RBI and Government have shown success in maintaining macroeconomic stability. Future focus should be on addressing supply-side constraints while maintaining prudent demand management.

Viva-Ready Summary Points. Key Takeaways for Examination. 

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• Inflationary Gap: Excess of aggregate demand over aggregate supply at full employment (Keynesian concept)

• AD Components: C + I + G + (X-M) - consumption, investment, government spending, net exports

• Diagram: Vertical distance between AD and 45° line at full employment output (Yf)

• Occurs during expansionary phase of business cycle

• Demand-Pull: Fiscal deficit (~5.1% GDP), credit expansion, rising incomes, low interest rates

• Supply-Side: Weather disruptions, infrastructure gaps, agricultural bottlenecks, supply chain issues

• Recent Examples: Vegetable prices up 26-89% (Dec 2024) due to supply shocks

• Purchasing Power: Erosion of real income; households spend more for same goods

• Income Distribution: Regressive impact - poor spend 58% on food vs rich

• Macro Stability: Reduced savings, investment uncertainty, wage-price spiral risk

• RBI (Monetary): Inflation targeting (4% ±2%), repo rate at 6.5%, CRR at 4%, OMOs

• Government (Fiscal): Fiscal consolidation, buffer stock management, strategic imports, stock limits

• Coordination: Essential for effective inflation management

• CPI Inflation: Declined from 5.4% (FY24) to 4.9% (FY25) - within RBI target

• Food Inflation: Vegetables & pulses contribute 32.3% to overall inflation

• Future Projection: RBI & IMF project ~4% inflation in FY26

• Demonstrates effective policy coordination

✓ Remember the diagram - Keynesian cross showing inflationary gap

✓ Quote recent data - CPI at 4.9%, repo rate 6.5%

✓ Emphasize dual causation - both demand and supply factors

✓ Highlight policy coordination - RBI + Government working together

Inflationary Gap in India: Causes and Consequences

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