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An inflationary gap occurs when the actual output (real GDP) of an economy exceeds its potential output. In other words, the economy is producing more goods and services than it can sustain in the long term. This situation typically leads to inflation, as the excess demand for goods and services puts upward pressure on prices. The term "inflationary gap" is given because inflation is a key characteristic of an expanding economy that is producing beyond its potential level. Example: Suppose the potential output of an economy is determined by the maximum amount of goods and services that can be produced when the labor force is at full employment. If the actual output of the economy is higher, meaning that more goods and services are being produced than the labor force can sustain, then an inflationary gap exists.

A recessionary gap occurs when the actual output (real GDP) of an economy is less than its potential output. In this case, the economy is not producing as many goods and services as it is capable of, resulting in unemployment and underutilized resources. The term "recessionary gap" comes from the fact that such a situation often leads to a recession, as firms cut back on production, investment, and hiring. Example: Using the same potential output definition as in the previous example, if the actual output is lower than potential output, that means that the labor force is not being fully utilized and the economy is underperforming, resulting in a recessionary gap. In summary, an inflationary gap occurs when an economy is producing at a level higher than its potential output, leading to inflation and economic expansion. On the other hand, a recessionary gap is when an economy is producing at a level lower than its potential output, which leads to unemployment, underutilized resources, and economic downturns. Understanding these concepts is essential for gauging the health of an economy and implementing appropriate policy measures.