Explain the role of legal reserve ratio and Bank rate in correcting inflationary gap in an economy.

Question

Accepted Answer

**Role of Legal Reserve Ratio and Bank Rate in correcting inflationary gap:**

**Legal Reserve Ratio (CRR/SLR):**
- When the Central Bank increases CRR, commercial banks must keep more reserves with the central bank
- This reduces the funds available with banks for lending
- Reduced lending capacity leads to lower credit creation in the economy
- Lower credit availability reduces consumption and investment expenditure
- Aggregate demand falls, helping to correct the inflationary gap

**Bank Rate:**
- When the Central Bank increases the bank rate, the cost of borrowing from the central bank rises
- Commercial banks increase their lending rates to maintain margins
- Higher interest rates discourage borrowers from taking loans
- This reduces credit availability and aggregate demand in the economy
- The reduction in AD helps to close the inflationary gap