Inflationary gap is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy.
Monetary measures to correct the inflationary gap:
(i) Cash Reserve Ratio: Cash Reserve Ratio is that percentage of bank deposits which are held as reserves with the Central Bank. Central Bank has the right to fix CRR. The Central Bank can reduce the inflationary gap by raising CRR. Raising CRR will reduce the lending capacity of the commercial banks. Lower lendings will leads to a fall in aggregate demand helpful in reducing inflation.
(ii) Repo Rate: In the case of inflation, RBI will try to reduce the amount of money in circulation by increasing the repo rate. When the repo rate is increased, banks will borrow less from RBI and hence the amount of money they will be lending to the public also decrease. A fall in the money supply means to fall in AD.
