Explain the concept of Inflationary Gap. Explain the role of Repo Rate in reducing this gap.
Explain the concept of Inflationary Gap. Explain the role of Repo Rate in reducing this gap.
If equilibrium level of income is determined after the stage of full employment, it is a situation of excess demand. Excess demand refers to the situation when aggregate demand (AD) is more than the aggregate supply (AS) corresponding to full employment level of output in the economy. Excess demand gives rise to inflationary gap.
Inflationary gap refers to the gap by which actual aggregate demand exceeds the aggregate demand required to establish full employment equilibrium. As a result of excess demand, prices increase because corresponding to increase in demand, output cannot increase.
Repo rate is the rate of interest charged by Central Bank on loans given to commercial banks. During a situation of excess demand leading to inflation, the Central Bank raises the repo rate which discourages commercial banks from borrowing from the Central Bank. Increase in repo rate foreces commercial banks to increase their own lending rates thus making credit costlier. As a result, the demand for loans falls discouraging investment. Also, a reduction in availability of credit helps in correcting the situation of excess demand and reducing inflationary gap.
If equilibrium level of income is determined after the stage of full employment, it is a situation of excess demand. Excess demand refers to the situation when aggregate demand (AD) is more than the aggregate supply (AS) corresponding to full employment level of output in the economy. Excess demand gives rise to inflationary gap.
Inflationary gap refers to the gap by which actual aggregate demand exceeds the aggregate demand required to establish full employment equilibrium. As a result of excess demand, prices increase because corresponding to increase in demand, output cannot increase.
Repo rate is the rate of interest charged by Central Bank on loans given to commercial banks. During a situation of excess demand leading to inflation, the Central Bank raises the repo rate which discourages commercial banks from borrowing from the Central Bank. Increase in repo rate foreces commercial banks to increase their own lending rates thus making credit costlier. As a result, the demand for loans falls discouraging investment. Also, a reduction in availability of credit helps in correcting the situation of excess demand and reducing inflationary gap.
