Question

Explain Deflationary Gap and the role of 'Open Market Operations' in reducing this gap.

Answer 1

Deflationary Gap is the amount by which the aggregate demand falls short of aggregate supply at the full employment level. It is called deflationary because it leads to a fall in the price level.

Open Market Operations refer to buying and selling of government securities by the central bank in the open market. The central bank can reduce this gap by buying securities. The money flows out from Central bank into the commercial banks. This raises lending capacity of commercial banks and therefore banks lend more. Spending now rises which reduces the deflationary gap.