Explain the concept of 'inflationary gap'. Also, explain the role of 'legal reserves' in reducing it.
CBSE OUTSIDE DELHI - SET 1 2012
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Inflationary Gap refers to the excess of Aggregate Demand over Aggregate Supply at full employment level of income. It is called inflationary because it brings in inflationary tendencies.
Legal reserves refer to that part of bank deposits which commerical banks are legally required to keep in the form of cash partly with themselves (Statutory Liquidity Ratio) and partly with the central bank (cash reserve ratio). In case of inflationary gap, the central bank can increase the legal reserve ratio (LRR) so that less money is available to the banks for lending. Borrowings are reduced. AD falls.
Legal reserves refer to that part of bank deposits which commerical banks are legally required to keep in the form of cash partly with themselves (Statutory Liquidity Ratio) and partly with the central bank (cash reserve ratio). In case of inflationary gap, the central bank can increase the legal reserve ratio (LRR) so that less money is available to the banks for lending. Borrowings are reduced. AD falls.
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