Explain the concept of "deflationary gap" and the role of "Open Market Operations" in reducing this gap.
Explain the concept of "deflationary gap" and the role of "Open Market Operations" in reducing this gap.
If equilibrium level of income is determined before the stage of full employment, it is a situation of deficient demand. This situation arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap.
In such a situation, due to the inadequacy of demand, production will be less and therefore involuntary unemployment will be created. This means that all the resources will not be fully employed. Therefore, the deficiency in aggregate demand at full employment level is the measure of deficient demand.
Role of Open Market Operations: Open market operations refer to sale and purchase of government securities in the open market by the Central Bank. During deficient demand, the Central Bank starts purchasing securities from the open market. Those who sell receive payments by cheques from the Central Bank. The money flows out from Central Bank into commercial banks. This raises lending capacity of commercial banks. As banks lend more, spending rises which increases the money supply in the economy, which further increases the level of aggregate demand in the economy thereby correcting the situation of deficient demand and reducing the deflationary gap.
If equilibrium level of income is determined before the stage of full employment, it is a situation of deficient demand. This situation arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap.
In such a situation, due to the inadequacy of demand, production will be less and therefore involuntary unemployment will be created. This means that all the resources will not be fully employed. Therefore, the deficiency in aggregate demand at full employment level is the measure of deficient demand.
Role of Open Market Operations: Open market operations refer to sale and purchase of government securities in the open market by the Central Bank. During deficient demand, the Central Bank starts purchasing securities from the open market. Those who sell receive payments by cheques from the Central Bank. The money flows out from Central Bank into commercial banks. This raises lending capacity of commercial banks. As banks lend more, spending rises which increases the money supply in the economy, which further increases the level of aggregate demand in the economy thereby correcting the situation of deficient demand and reducing the deflationary gap.
