An inflationary gap is characterized by what situation in the economy?

• A. Actual output is equal to potential output
• B. Unemployment is at its natural rate
• C. Actual output exceeds potential output
• D. Decrease in the aggregate price level

Answer: (C)

An inflationary gap occurs when the actual output of an economy surpasses its potential output. This situation typically reflects an economy that is operating above its sustainable capacity, leading to lower unemployment rates and increased demand for goods and services. As a result, businesses may struggle to keep up, which can create upward pressure on prices, often resulting in inflation.

When actual output exceeds potential output, it indicates that resources—particularly labor—are being utilized beyond their normal capacity, leading to higher costs and ultimately driving prices upwards. This state is often associated with economic booms or strong consumer and business confidence, where spending outpaces supply capabilities.

In contrast, the other choices describe conditions that either align with equilibrium (like actual output equal to potential output) or indicate a stabilization scenario (such as unemployment at its natural rate) or a decrease in the aggregate price level, which would not be consistent with an inflationary gap. Thus, the definition of an inflationary gap specifically highlights the excess of actual output over potential output as its characteristic feature.