Explain the concept of 'inflationary gap'. Also explain the role of 'legal reserves' in reducing it.
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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 things-
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.
Legal reserve ratio or cash reserve ratio refers to the percentage of total demand
deposits of the commercial banks which they must keep as cash reserves
with the RBI.
In order to control excess demand, the central bank
must increase CRR so the credit creation capacity of
the commercial banks and the money supply in an economy get decreased.
As a result aggregate demand will also fall.