Question

State two measures by which a central bank can attempt to reduce the inflationary gap.

Answer 1

Two measures by which a central bank can check the inflationary gap are as follows:

1) Increase in bank rate: During inflation bank rate is increased. As a follow-up action, the commercial banks rise the market rate of interest. This reduces the demand for credit and thus inflation can be combated.

2) Open market operation is the policy that focuses on increasing and decreasing the stock of liquidity with the people, through sale and purchase of securities by the central bank. During excess demand or inflation, the central bank tries to sale securities. Sale of securities reduces purchasing power from the market. Consequently, aggregate demand is decreased and excess demand or inflationary gap gets combated.