Question

Also explain the role of ‘margin requirements’ in reducing it.

Answer 1

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 and EY is aggregate demand at the full employment level of output.

Now, let us suppose the actual aggregate demand for output is CY, which is less than EY. The vertical distance between the actual level of aggregate demand CY and the full employment level of output EY that is, EC represents the deflationary gap.

Role of Margin Requirement to Correct Deflationary Gap

Margin requirement is the difference between the market value of the securities and the value of loan granted. When there exists a deflationary gap in an economy, the central bank reduces the margin requirements. A reduction in the margin requirements implies that the loans become easily available and accessible. Thus, the demand for loans and credit increases. This results in a greater flow of money supply in the economy, which rises the level of aggregate demand, thereby, the deflationary gap gets corrected.