Above Full-Employment Equilibrium

Above full-employment equilibrium is a macroeconomic term used to describe a situation in which an economy’s real gross domestic product (GDP) is in excess of its long-run potential level. Accordingly, the amount that the current real GDP is greater then the historic average is called an inflationary gap, as this will create inflationary pressures in this particular economy.

An economy that is operating above its full-employment equilibrium simply means that it is producing goods and services, as measured by its GDP, at a higher level than either its potential or its long-run average levels. The amount by which the current real GDP is greater than the historic average is called an inflationary gap. When the market is in equilibrium, there will not be any excess supply in the short run. But an overly active economy will create more demand for goods and services, which will push prices and eventually wages upward, as companies increase production to meet demand. Ultimately, this results in a situation of too much money chasing too few goods, and creates inflationary pressures in the economy, which isn’t sustainable for long periods.

For one thing, companies can only ramp up production so much before hitting capacity constraints. So increases in supply will be finite. Over time, the economy and employment markets will shift back into equilibrium as higher prices bring demand back down to normal run-rate levels.

When an economy is at full employment, a level that varies by economy and can change over time, all available labor is being utilized. A number of factors can cause employment to rise beyond its equilibrium level. A significant shift in demand, or “demand shock," government spending, for example, a buildup in military spending to support war effort; or through government stimulus, such as a tax cut, can push demand high enough to exceed full employment. A good example of the former is the growth of the U.S. economy during World War II. These types of demand-stimulating activities from government is known as expansionary fiscal policy.

An increase in the demand for a country’s goods and services — greater export demand — as well as an increase in household consumption, can cause an inflationary gap.

Fiscal policies such as increasing taxes or reducing spending and/or monetary policy (central bank) actions or increasing the level of interest rates can be used to bring an overheating economy back into equilibrium. But these take time to make an impact, and also come with risks of overcorrecting and causing a recessionary gap.