I read that when there is an inflationary gap, the government tries to reduce it
ID: 1248252 • Letter: I
Question
I read that when there is an inflationary gap, the government tries to reduce it by raising prices or raising interest rates. The way I understand it, raising prices will have the effect of making the currency stronger, and therefore will lower exports and increase. This will have the effect of cooling down the economy. And when the gov raises interest rates, investment goes down, which also has the effect of cooling down the economy.
Yet why is the government trying to cool down the economy? what’s so bad about having an inflationary gap? Is it because it means the economy has too much inflation? If so, so what – after all, the economy is growing, so why cool it off?
Thank you
Explanation / Answer
When the economy is facing a problem of demand pull inflation. Where the price level had surged due to the shift in the aggregate demand curve.
This situation arises when there is a higher Government spending and a positive sentiment in the investors as the expected rate of return on their investment is higher than the interest rate.
Due to this behavior, there is a lower unemployment rate.
These factors had caused to increase the aggregate output. But due to higher price level, the aggregate out put will not increase at an estimated value. So it will land up below the estimated value, creating inefficiency in the economy.
To explain further. The measure of real health of economy is Real GDP.
Due to inflation the GDP will be very high at the current prices, which is also called as nominal GDP.
So, Nominal GDP is much higher than the actual output or real output due to higher price level. And the customer will pay a higher price than the actual marginal cost incurred on a particular comodity.
So, in the case of demand pull inflation, the pie looks big or fat from outside but the actual benifit an economy receives will be lesser causing an inefficient allocation.
So, ideal level of output is potential GDP where the prices are stable.
Fiscal Policy Measure
To reduce the prices, the Government can adopt a contractual fiscal policy
Government Spending: It reduces the government spending, thus resulting in a decrease in the overall output.
It increases the taxes, this result in a reduction in the disposable income to the people, and thus reducing the aggregate demand.
Monitory Policy:
To reduce inflation, the monitory measure that can be adopted is reducing the money supply. i.e., Central bank (Fed) contracts the money supply, or drains out money from the market;
It has options like increasing Reverse repo rate, CRR and SLR rate.
Reverse Repo rate: it is the rate at which the central bank (federal bank) borrows money from the banks, when the central bank increases the reverse repo rate, the commercial banks are always happy to lend money to central bank, since it is secure and gives a healthy returns.
CRR is the cash reserve ratio, it is the amount (in the from of a deposit), a commercial bank need to maintain with the central bank (federal bank). By increasing the CRR ratio, the commercial banks need to deposit more money in the central bank (federal bank), and hence money supply can be reduced.
SLR is statutory liquidity ratio, it is the amount that the commercial bank need to maintain in the form of cash, gold or government approved securities, to meet any time demand of the bank customers (who deposited money in the respective banks).
So by increasing the reverse repo rate, CRR and SLR rates money supply can be reduced. The decreased money supply increases the interest rates, motivating the public to save rather than spending (consumption and investment spending), and this decreases the aggregate demand, decreasing the inflation.