Railway
Excess of aggregate demand over the aggregate supply at full employment leads to:
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Answer: Option A — Inflationary gap
Detailed Solution
The ideas of inflationary and deflationary gaps come from the macroeconomic theory of John Maynard Keynes, especially his book "The General Theory of Employment, Interest and Money" (1936).
In this theory, the equilibrium level of output and employment is determined by aggregate demand (AD), the total spending on goods and services in the economy, and aggregate supply (AS), the total output that firms are willing to produce. Full employment is the level at which all those who are willing and able to work at the prevailing wage rate are employed, and resources are fully used.
An inflationary gap arises when aggregate demand is greater than aggregate supply at the full employment level of output. In other words, people, businesses and the government want to buy more goods and services than the economy can produce when all resources are already fully employed. Since output cannot increase further, the excess demand pushes up prices instead, causing demand-pull inflation. The inflationary gap is the amount by which actual aggregate demand exceeds the aggregate demand needed for full employment equilibrium.
To reduce an inflationary gap, governments and central banks use contractionary policies:
- Fiscal measures: reducing government spending and increasing taxes.
- Monetary measures: raising the repo rate and the bank rate, increasing the CRR and SLR, and selling government securities (open market operations).
A deflationary gap arises when aggregate demand is less than aggregate supply at full employment. Demand is too low to buy all the output that could be produced, leading to unemployment and falling prices. It is corrected by expansionary policies, such as increasing government spending, cutting taxes and lowering interest rates.
Why not the other options?
- ✗A deflationary gap occurs when aggregate demand falls short of aggregate supply at full employment.
- ✗A liquidity trap is a situation where interest rates are very low and people hold money instead of investing, making monetary policy ineffective.
- ✗Fiscal deficit is the gap between the government's expenditure and its non-borrowed receipts.
Quick tip
Remember: Inflationary gap = excess demand at full employment (demand-pull inflation, cure: contractionary policy); deflationary gap = deficient demand (unemployment); concepts from Keynes (1936).
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Inflation & Price Indices — Preparation
This question tests your understanding of Inflation & Price Indices, a key topic in the General Knowledge section. The detailed solution above uses a step-by-step approach to show the reasoning, and where available, a shortcut that helps you solve similar questions in under 90 seconds during the actual exam.
This topic covers inflation and deflation, the types and causes of inflation (demand-pull and cost-push), stagflation, the Consumer Price Index (CPI) and Wholesale Price Index (WPI), and the measures used to control inflation. Questions commonly ask which index the RBI uses for its inflation target (CPI combined), who publishes CPI and WPI, and what terms such as stagflation, deflation and disinflation mean. Remember that inflation reduces the purchasing power of money and generally benefits borrowers at the cost of lenders. Practise the inflation and price indices questions below, written in the style of the general awareness sections of exams such as SSC, banking, railways, CUET GAT, MAH CET and CLAT. Each question comes with a detailed explanation that adds related facts, so every question helps you revise more than one point.