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Question
Explain the concept of ‘inflationary gap’. Also explain the role of ‘legal reserves’ in reducing it.
Solution
Inflationary gap refers to the difference (or gap) between the actual level of aggregate demand and the full employment level of demand that arises due to excess demand. This gap measures the amount of surplus in the level of aggregate demand.
In the above figure, the full employment equilibrium is at point E, where Aggregate Demand curve, AD1 and Aggregate Supply curve, AS intersect. At this equilibrium point, OY represents full employment level of income and EY is aggregate demand at the full employment level of output.
Now, let us suppose the actual aggregate demand for output is FY, which is higher than EY. The vertical distance between the actual level of aggregate demand FY and the full employment level of output EY that is, FE represents the inflationary gap.
Role of Legal Reserve Ratios to Correct Inflationary Gap
Legal Reserve Ratio (LRR) comprises of CRR and SLR.
CRR refers to the minimum proportion of the total deposits that the commercial banks have to maintain with the central bank in form of reserves. When there is inflationary gap in an economy, the central bank raises the CRR. Increase in CRR implies that the commercial banks are left with lesser amount of funds to lend out to the public. This implies that the lending capacity of the banks reduces, leading to a fall in the money supply in the economy. The fall in money supply reduces the level of aggregate demand. Thus, the inflationary gap is corrected.
SLR refers to the minimum percentage of assets to be maintained by the commercial banks with themselves in the form of either fixed or liquid assets. Similar to CRR, in order to correct the situation of inflationary gap, the central bank raises the SLR. A rise in the SLR restricts the commercial banks to pump additional money into the economy. This results in a fall in the money supply which subsequently leads to a reduction in inflationary gap.
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RELATED QUESTIONS
Answer the following question.
What role does it play in determining the credit creation power of the banking system? Use a numerical illustration to explain.
Banks are able to create credit many times more than initial deposits through ______.
The ______ creation is called credit creation.
What do you mean by credit creation by commercial banks?
Access to adequate and timely credit at affordable rates is critical for the rural poor to alleviate high cost debt and invest in livelihood opportunities. Despite the Government of India's best efforts, financial inclusion of the rural poor has been beset with multiple challenges. Lack of adequate banking infrastructure and human resources in rural areas, unplanned expansion leading to unviable bank branches and low levels of financial literacy amongst the rural populace have been some of the key challenges.
The most vulnerable communities, who often had no formal credit history or ability to provide collateral, have often been the worst affected. Inability to access loans from banks meant that the poorest had to resort to moneylenders for loans at unreasonably high rates of interest that invariably led them into a toxic debt trap.
In this context, the SHG-Bank Linkage programme, formalised by the National Bank for Agriculture and Rural Development (NABARD) in 1995, synthesizes 'formal financial systems' (in terms of a formal institution providing credit) with the 'informal sector' (comprising of rural poor with no formal credit history), has emerged as a preferred vehicle for providing financial services to the hitherto unbanked poor.
Community Based Repayment Mechanisms (CBRMs) have been institutionalised at branches involved in financing SHGs to monitor and ensure timely repayment of loans by SHGs. The number of SHGs with outstanding bank loans stands at nearly 5 million today, implying that the program has brought formal banking services to over 50 million women.
What could be the main reason for the institutionalization of Community Based Repayment Mechanisms (CBRMs)?
Access to adequate and timely credit at affordable rates is critical for the rural poor to alleviate high cost debt and invest in livelihood opportunities. Despite the Government of India's best efforts, financial inclusion of the rural poor has been beset with multiple challenges. Lack of adequate banking infrastructure and human resources in rural areas, unplanned expansion leading to unviable bank branches and low levels of financial literacy amongst the rural populace have been some of the key challenges.
The most vulnerable communities, who often had no formal credit history or ability to provide collateral, have often been the worst affected. Inability to access loans from banks meant that the poorest had to resort to moneylenders for loans at unreasonably high rates of interest that invariably led them into a toxic debt trap.
In this context, the SHG-Bank Linkage programme, formalised by the National Bank for Agriculture and Rural Development (NABARD) in 1995, synthesizes 'formal financial systems' (in terms of a formal institution providing credit) with the 'informal sector' (comprising of rural poor with no formal credit history), has emerged as a preferred vehicle for providing financial services to the hitherto unbanked poor.
Community Based Repayment Mechanisms (CBRMs) have been institutionalised at branches involved in financing SHGs to monitor and ensure timely repayment of loans by SHGs. The number of SHGs with outstanding bank loans stands at nearly 5 million today, implying that the program has brought formal banking services to over 50 million women.
Which of the following is likely to be the MAIN objective of this programme?
''The process of credit creation by commercial banks comes to an end when the total of required reserves become equal to the initial deposits."
With the help of a numerical example, prove that the given statement is true.
Deposits made by the people from their own resources are called ______.
If legal reserve ratio is 20%, the value of money multiplier would be ______.
Suppose in an economy, the initial deposit of ₹ 400 crores lead to the creation of total deposits worth ₹ 4000 crore. Then the value of reserve requirements would be ______.
Match the following and select the correct option.
| Column A | Column B | ||
| (i) | A deposit created by a customer | A. | Term deposit |
| (ii) | A deposit created by bank when loan is granted | B. | Demand deposits |
| (iii) | Deposits payable by bank on demand | C. | Initial deposit |
| (iv) | Deposits the amount of which can be withdrawn only after a fixed period of time | D. | Secondary deposit |
Which of these banks formulates the credit control tools?
Match the following:
| Column I | Column II | ||
| A. | Primary deposits | (i) | Payable on demand |
| B. | Derivative deposits | (ii) | Deposits for a fixed period of time |
| C. | Demand deposits | (iii) | Cash deposits of people |
| D. | Term deposits | (iv) | Deposits created by banks (or loan deposits) |
Read the following statements - Assertion (A) and Reason (R). Choose one of the correct alternatives given below:
Assertion (A): Credit Creation comes to an end when total cash reserves become equal to the initial deposits.
Reason (R): The value of money multiplier is determined by Legal Reserve Ratio (LRR).
Match the following:
| Column I | Column II | ||
| A. | Formula of Money Multiplier | (i) | Inverse |
| B. | Money multiplier = 4 | (ii) | Money multiplier = 10 |
| C. | Relationship between LRR and money multiplier | (iii) | LRR = 0.25 |
| D. | LRR = 0.1 | (iv) | `1/"LRR"` |
