Explain the concept of Inflationary Gap. Explain the role of 'Repo Rate' in reducing the gap.

Inflationary Gap-Inflationary gap is the excess of AD over and above its level required to maintain full employment equilibrium in the economy. Inflationary gap generates extra pressure on the existing flow of goods and services at the level of full employment. Accordingly, prices tend to rise. The output will not increase.

Repo rate is the rate at which the Central Bank lends money to the Commercial Banks. To correct the situation of Inflationary Cap, Repo Rate is increased. As a follow-up action, the Commercial banks raise the market rate of interest (the rate at which the Commercial Banks lends money to the consumers and the investors). This reduces demand for credit. Consequently, consumption expenditure and investment expenditure are reduced. Implying a reduction in Aggregate Demand, as required to correct Inflationary Gap.