Q&A: Does a positive output gap always mean rising inflation?

A student asks “Does a positive output gap always mean rising inflation?”

The answer is no - indeed beware statements in economics that carry the word ALWAYS because we can (always!) find a way of explaining a situation where the statement can be falsified!

When there is a positive output gap then the economy is operating with a level of actual GDP above the estimated potential level of national output. This indeed can cause some inflationary pressures to build up

a) High demand encourages businesses to raise price and enjoy higher profit margins
b) If SRAS is inelastic, attempts to expand output might be accompanied by rising wage, raw material and component costs

But inflationary (and deflationary) pressures come from many sources - both internal and external and from the demand and supply-side of the economy.

Some come direct from the domestic economy, for example the decisions of the utility companies providing electricity or gas or water on their prices for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets. A rise in government VAT would also be a cause of increased inflation because it increases a firm’s production costs.

Inflation can also come from external sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages. Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of the pound against other currencies might cause higher import prices – which feeds through directly into the consumer price index.

So even if there was a small positive output gap there might be other factors such as a strong exchange rate, weaker global commodity prices or the impact of new technology keeping inflationary pressures in check.