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Question
Explain the role of 'Open Market Operations' in reducing Deflationary Gap
Solution
Aggregate demand is the AD curve and aggregate supply is the AS curve (as shown in the diagram below). While the aggregate demand curve and the aggregate supply curve intersect each other, the full employment equilibrium is attained at Point E. OY is the full employment level of output, and EY is the aggregate demand at full employment level of output. If the aggregate demand decreases below the full employment level of output from EY to CY, then the economy will have deficient demand, i.e. situation of the deflationary gap (EY − CY = EC).
The central bank overcomes the deflationary situation by buying the securities in the market. This increases the circulation of money and it enables the people to increase their ability to purchase more. In this way, the aggregate demand increases to the level of aggregate supply and the economy attain equilibrium.
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