Question

Explain the role of legal reserve ratio and Bank rate in correcting inflationary gap in an economy.

Answer 1

Role of Legal Reserve Ratios to Correct Inflationary Gap:

Legal Reserve Ratio (LRR) comprises of CRR and SLR.

CRR refers to the minimum proportion of the total deposits that the commercial banks have to maintain with the central bank in form of reserves. When there is inflationary gap in an economy, the central bank raises the CRR. Increase in CRR implies that the commercial banks are left with lesser amount of funds to lend out to the public. This implies that the lending capacity of the banks reduces, leading to a fall in the money supply in the economy. The fall in money supply reduces the level of aggregate demand. Thus, the inflationary gap is corrected. 

SLR refers to the minimum percentage of assets to be maintained by the commercial banks with themselves in the form of either fixed or liquid assets. Similar to CRR, in order to correct the situation of inflationary gap, the central bank raises the SLR. A rise in the SLR restricts the commercial banks to pump additional money into the economy. This results in a fall in the money supply which subsequently leads to a reduction in inflationary gap.

Role of Bank rate to Correct Inflationary Gap:

The bank rate, also known as the rediscount rate, is the interest rate at which the central bank lends to commercial banks or rediscounts commercial bills brought by commercial banks in times of financial need.

When it comes to LRR, the loanable capacity of a commercial bank is reduced by the amount of LRR. By increasing the LRR, the commercial bank's excess reserve is reduced, limiting the commercial bank's credit-granting capacity. Similarly, when the bank rate rises, the loan becomes more expensive for commercial banks, which raise interest rates on loans to general customers. Both of these increases reduce aggregate demand and the inflationary gap.