Question

Discuss two monetary measures to correct the deflationary gap.

Discuss any two monetary measures to reduce the deflationary gap.

Answer 1

Expansionary monetary policy should be pursued so as to increase consumption expenditure and also to stimulate investment in the economy:

1. Bank Rate: The country’s central bank should reduce the bank rate to address deficient demand in the economy. A decrease in the bank rate would lead to a corresponding decrease in the interest rates charged by commercial banks to their customers. Lower bank credit costs would increase the amount of credit borrowed from them. This will have an expansionary effect on the economy, as consumers and investors increase their borrowing from banks, leading to higher aggregate demand.
2. Open Market Operations: The central bank should pursue a policy of buying government bonds and other securities from commercial banks and the public. When the central bank buys government securities from the public and commercial banks by paying them in cash, the cash flow in the economy increases. This will increase commercial banks’ cash holdings. To that extent, banks will increase their loans and advances. This will have an expansionary effect on the economy.
3. Cash Reserve Ratio: The cash reserve ratio needs to be reduced to address deficient demand. A decrease in the CRR means that commercial banks are required to keep less cash with the central bank. Consequently, cash flow with commercial banks increases, thereby increasing the capacity of banks to grant loans and advances. This will have an expansionary effect on the economy. As a result, aggregate demand will increase.