explian the concept of inflationary gap? also explain the role of legal reserves in reducing it?
The answer to the concerned question is exhaustively covered in our study material. You can find it in the below mentioned link.
(for the concept of Inflationary Gap)
Legal Reserve Ratio (LRR) refers to that legal minimum fraction of deposits which the banks are mandate to keep as cash with themselves. The LRR is fixed in India by the Reserve Bank of India.
LRR has two components:
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
(i) Cash Reserve Ratio (CRR)
It refers to the minimum amount of funds that a commercial bank has to maintain with the Reserve Bank of India, in the form of deposits. For example, suppose the total assets of a bank are worth Rs 200 crores and the minimum cash reserve ratio is 10%. Then the amount that the commercial bank has to maintain with RBI is Rs 20 crores. If this ratio rises to 20%, then the reserve with RBI increases to Rs 40 crores. Thus, less money will be left with the commercial bank for lending. This will eventually lead to considerable decrease in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply.
(ii) Statutory Liquidity Ratio (SLR)
SLR is concerned with maintaining the minimum reserve of assets with RBI, whereas the cash reserve ratio is concerned with maintaining cash balance (reserve) with RBI. So, SLR is defined as the minimum percentage of assets to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit is reduced by increasing this liquidity ratio and vice-versa. In the previous example, this can be understood as rise in SLR will restrict the banks to pump money in the economy, thereby contributing towards decrease in money supply. The reverse case happens if there is a fall in SLR, as it increases the money supply in the economy.
The government can control excess demand through its fiscal and monetary
policy. The tools of Fiscal policy are:
(1) Expenditure policy - The government can curtail public expenditure, like road building, rural electrification schemes, and etc.,The government can use its discretionary measures, like reducing expenditure on public health care, education, defense, etc. It thereby restricting money inflow into the economy.
(2) Revenue policy - The government can raise tax rates, impose new taxes in order to reduce purchasing power from the economy. It can resort to public borrowing as a step to control excess demand.
The tools of Monetary policy are:
(1)Increase in the bank rate:The reserve bank can regulate and control the money supply by increasing the bank rate.This results in making credit more expensive and thereby discourage borrowings by the public.
(2) Open market operations: Reserve Bank can sell securities in the open market. This causes a decrease in the total money supply in the economy.
(3) Cash Reserve Ratio:CRR is the percentage of cash reserve that the banks have to maintain with the central bank. The central bank can raise the cash-reserve ratio, and thus curtail the bank’s lending capacity.
Inflationary gap is a situation when Actual demand is more than the aggregate demand at full employment level.
Under law, commercial banks are required to keep a minimum % of legal reserves. This is legal reserve ratio. There are two components. One, cash reserve ratio and trhe other statutory liquidity ratio.
In times of inflation, the central bank raises the LRR. this reduces the lending power of the banks. In this way credit availability is reduced. As a result, aggregate demand falls. Fall in AD thus reduces the inflation