question_answer

                                 

Explain the concept of 'inflationary gap'. Also explain the role of 'legal reserves' in reducing it.

Or

Explain the concept of 'deflationary gap'. Also explain the role of 'margin requirements' in reducing it.

 

Answer:

Inflationary Gap: The situation of inflationary gap arises when equilibrium is established after the stage of full employment. The excess of aggregate demand over aggregate supply at the full employment level is inflationary gap. For bringing equality between AD and AS as the full employment level AD has to be reduced because AS cannot be increased since all the resources are fully employed.

(i) Legal reserves: Legal reserves refer to a minimum percentage of deposits commercial banks have to keep as cash either with themselves or with the central bank. The central bank has the power to change it. When there is inflationary gap the central bank can raise the minimum limit of these reserves so that less funds are available to the bank for lending,

This will reduce Aggregate Demand.

(ii) Bank rate: Bank rate is the rate of interest which central bank charges from commercial banks for giving them loans. It bank rate is increased, the rate of interest for general public also goes up and this reduces the demand for credit by the public for investment and consumption. Therefore, for controlling the situation of inflationary gap, bank rate is increased. This ultimately will lead to the decline in the demand for credit Decline in the volume of credit as a component of money supply will have controlling pressure on inflationary forces.

Or

The situation of deflationary gap arises when equilibrium is established before the stage of full employment of output. In this case, at the full employment level, aggregate demand is less than aggregate supply. In the diagram, DEF is deflationary gap. For removing deflationary gap, the level of aggregate demand needs to be increased.

Margin requirements. Commercial banks never advance loans to its customers equal to the full value of collateral or securities. They always keep a margin with them, such as keeping a margin of 20% and advancing loans equal to 80% of value of security. The rate of margin is determined by the Central bank. In the situation of deflationary gap, this margin will be reduced so that more credit may be advanced against the security.