Inflationary Gap- When Aggregate Demand is greater than Aggregate Supply at full employment level, it is a situation of Inflationary Gap.
Deflationary Gap- When Aggregate Demand is less than Aggregate Supply at full employment level. It is a situation of Deflationary Gap.
(i) Role of Open Market Operations in Correcting Deflationary Gap in an Economy: Open Market Operations refers to sale and purchase of securities by the Central Bank on behalf of government in the open market. It directly affects the supply of money in the hands of Commercial Banks and citizens of the country. In case of Deflation, the Central Bank purchased securities from public.
It increases the supply of money in the economy and credit/money creation power of Commercial Banks. Thus, the Aggregate Demand increases and ultimately the economy attains equilibrium.
(ii) Role of Open Market operations in Correcting Inflationary Gap in an Economy: In case of Inflation, the Central Bank sell the securities to the public. It reduces the supply of money in an economy and credit/ money creation power of Commercial Banks. Thus, the Aggregate Demand decreases and ultimately the economy attains equilibrium.
(iii) Role of Bank Rate in Correcting Inflationary Gap: The rate at which the Central Bank lends money to Commercial Banks is termed as Bank Rate. In case of inflation the Central Bank increases the bank rate reduces the money creation power of Commercial Banks and also increases the market rate of interest which discourages public to borrow loans. The Aggregate Demand comes down and the inflation is corrected.
(iv) Role of Bank Rate in Correcting Deflationary Gap: In case of Deflation, the Central Bank reduces the bank rate to increase the supply of money in the economy. Reduction in bank rate increases the money creation power of Commercial Banks and also decreases the market rate of interest which induces public to borrow more. The aggregate demand increase and the deflation is corrected.
