Inflationary gap or excels demand may be defined as the excess of aggregate demand over aggregate supply at full employment.
Following are three measures to reduce inflationary gap :
1. Legal Reserves – Legal or statutory reserve is the fraction of total demand and time deposits which the commercial banks are required by central bank to keep with it. To reduce inflationary gap, central bank raises legal reserve ratio which in turn, reduces capacity of commercial banks to create credit.
2. Bank Rate – Bank rate means the rate of interest at which central bank lends to commercial banks. Any change in bank rate affects credit creation by commercial banks. An increase in bank rate leads to an increase in commercial banks’ lending rate of interest. As a result, credit becomes costlier because rate of interest is cost of credit. An increase in bank rate discourages commercial banks in borrowing from central bank. Thus, increase in bank rate reduces the quantum of credit with the commercial banks that can be advanced to public as loan.
3. Open Market Operations – Open market operation means policy of central bank to sell and buy government securities in the market. Open market operations affect the volume of cash reserves with the commercial banks and, thus the overall availability of credit. Sale of government securities by central bank to commercial banks reduces the cash reserves with the banks resulting in decline of credit. During the phase of inflationary gap, central bank sells government securities to commercial banks which motivates the commercial banks to create less credit.
