Question

Explain the concept of Inflationary Gap. Explain the role of 'Repo Rate' in reducing the gap.

Answer 1

Inflationary gap is also referred to as excess demand. When aggregate demand is greater than aggregate supply, at full employment level in the economy, it is referred to as inflationary gap or excess demand. This situation actually results in an increase of prices, that is inflation.
Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF).



In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap. That is,
FY – EY = FE (Inflationary Gap)
In the figure, AD1 and AS represent the aggregate demand curve and aggregate supply
curve respectively. The economy is at full employment equilibrium at point “E”, where AD1 intersects AS curve. At this equilibrium point, OY represents full employment level and EY is aggregate demand at the full employment level of output.
Suppose that the actual aggregate demand for output is FY, which is higher than EY. This implies that actual aggregate output demanded by the economy FY is more than the potential (full employment) aggregate output EY. Thus, the economy is facing surplus demand. This situation is termed as excess demand. As a result of the excess demand, inflationary gap arises. The inflationary gap is measured by the vertical distance between the actual aggregate demand for output and the potential (or full employment level) aggregate demand. In other words, the distance between FY and EY, i.e. FE represents the inflationary gap.

Repo rate refers to the rate at which the central bank lends to the commercial bank. In case of inflationary gap, the central bank would increase repo rate. An increase in the repo rate increases the cost of borrowings for the commercial banks. This discourages the demand for loans and borrowings. Thereby, the consumption expenditure falls, and hence aggregate demand falls.

Answer 2

Answer:

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.

It implies two types that are:

1) Planned aggregate demand in the economy happens to exceed its full

employment level.

2)The level of aggregate demand surpasses the level of aggregate

supply even when the available factors are fully utilized.

Role of Repo rate:

Repo rate relates to the loans offered by the RBI to the commercial banks not without collateral. During inflation Repo rate is increased. As a follow-up action, the commercial banks rise the market rate of interest. This reduces the demand for credit and thus inflation can be combated.