Question

What is 'inflationary gap'? Explain the role of Cash Reserve Ratio in removing this gap.

Answer 1

Excess demand or inflationary gap is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy.

Cash reserve ratio refers to the percentage of total demand deposits of the commercial banks which they must keep as cash reserves with the RBI.

In order to control excess demand, the central bank must increase CRR so the credit creation capacity of the commercial banks and the money supply in an economy get decreased. As a result aggregate demand will also fall.