Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What is the inflationary gap?

1. An increase in prices resulting from lowered demand

2. An increase in demand leading to an increase in prices as resources are fully employed

3. A situation where prices decrease despite increased demand

4. An increase in money supply causing deflation

The correct answer is: An increase in demand leading to an increase in prices as resources are fully employed

The inflationary gap refers to a situation in which an economy's actual output exceeds its potential output, typically when resources are fully employed. This leads to an increase in demand that surpasses the economy's ability to produce goods and services at sustainable levels, causing upward pressure on prices. When demand increases significantly and resources like labor and capital are utilized to their maximum capacity, businesses may struggle to meet this demand. As they face constraints in expanding production rapidly, they often resort to raising prices, resulting in inflation. This phenomenon illustrates the relationship between demand and supply within an economy and highlights how economies operate beyond their potential capacity, leading to inflationary pressures. In contrast, other options describe different scenarios. For example, an increase in prices from lowered demand does not reflect the conditions of an inflationary gap; instead, it suggests deflationary or recessionary conditions. Similarly, a decrease in prices despite increased demand indicates a divergence from typical market dynamics, which is not characteristic of an inflationary gap. Lastly, an increase in money supply that causes deflation contradicts the fundamental concept of an inflationary gap, where excessive demand leads to price rises rather than drops.