Question

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

Answer 1

Inflationary gap refers to the difference (or gap) between the actual level of aggregate demand and the full employment level of demand that arises due to excess demand. This gap measures the amount of surplus in the level of aggregate demand.  

In the above figure, the full employment equilibrium is at point E, where Aggregate Demand curve, AD₁ and Aggregate Supply curve, AS intersect. At this equilibrium point, OY represents full employment level of income and EY is aggregate demand at the full employment level of output.

Now, let us suppose the actual aggregate demand for output is FY, which is higher than EY. The vertical distance between the actual level of aggregate demand FY and the full employment level of output EY that is, FE represents the inflationary gap.

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.