Equilibrium GDP and Prices - Inflationary Gap

Increases in AD lead to economic expansions as real GDP and employment increase. If the expansion drives the economy beyond its production capacity, however, inflation will occur.

Factors that stimulate AD and shift the AD curve to the right:

higher government spending

lower taxes

a more optimistic outlook among consumers and businesses

a weaker domestic currency

rising equity and housing prices

an increase in the money supply

An inflationary gap occurs when the economy’s short-run level of equilibrium GDP is above potential GDP, resulting in upward pressure on prices.

Government and/or central bank can use the tools of fiscal and monetary policy to control inflation by shifting the AD curve to the left.

Fiscal: raise taxes or cut government spending.

Monetary: the central bank can reduce bankreserves, resulting in a decrease in the growth of the money supply and higher interest rates.

If there is an expansion caused by an increase in AD, the following conditions are likely to occur:

Corporate profits will rise.

Commodity prices will increase.

Interest rates will rise.

Inflationary pressures will build.

This suggests the following investment strategy:

Increase investment in cyclical companies.

Reduce investments in defensive companies.

Increase investments in commodities and commodity-oriented equities.

Reduce investments in fixed-income securities, especially longer-maturity.

Raise exposure to speculative fixed-income securities (junk bonds).