Inflationary gap is the situation when AD exceeds AS corresponding to the full employment income level of income/output.
Measures to reduce the inflationary gap are :
(i) Decrease in government spending
(ii) Increase in the level of taxes.
(iii) Increase in bank rate
Detailed Answer :
The excess of aggregate demand over aggregate supply at full employment is called inflationary gap. Inflationary Gap is the measurement of excess demand and is equal to the difference between Aggregate Demand beyond full employment AD and Aggregate Demand at full employment (ADF). Inflationary Gap = AD – ADF
Measure to Correct the Gap :
1. Statutory Liquidity Ratio : SLR refers to a fixed percentage of the total assets of a bank in the form of cash or other liquid assets that is required to be maintained by the bank. During the situation of Inflationary Gap, SLR is increased. This reduces the credit creation capacity of Commercial Banks and reduces the flow of money in the economy. As a result of that, the aggregate demand comes down and ultimately the economy attains equilibrium.
2. Repo rate : is the rate at which the Central Bank lends money to the Commercial Banks. To correct the situation of Inflationary Gap, Repo Rate is increased. As a follow-up action, the Commercial banks raise the market rate of interest (the rate at which the Commercial Banks lends money to the consumers and the investors). This reduces demand for credit. Consequently, consumption expenditure and investment expenditure are reduced. Implying a reduction in Aggregate Demand, as required to correct Inflationary Gap.
3. Legal reserves : refer to that part of bank deposits which Commercial Banks are legally required to keep in the form of cash partly with them selves ( Statutory Liquidity Ratio) and partly with the Central Bank (Cash Reserve Ratio). In case of Inflationary Gap, the Central Bank can increase the Legal Reserve Ratio (LRR) so that less money is available to the banks for lending. Borrowings are reduced. AD falls.
