The output gap is an economic measure of the difference between the actual output of the economy and its expected output. An output gap indicates that the economy is going through an inefficient rate and the economy is either overworking or underworking its resources. The output gap plays a main role in the policymaking of the central bank. In order to close the output gaps the central banks used to adopt various monetary policies in order to stimulate the economic growth.
The open market operations refer to the central bank’s buying and selling of government securities in the open market in order to increase or decrease the amount of money in the banking system. The purchase of the securities brings money in the banking system and that helps in the closure of the output gaps. The sales of the securities will contract the economy.
The central banks can use various methods of open market operations but the most common method is the issue of government bonds which allows the central bank to control the reserve balances held by the bank which helps the central bank to increase or decrease the short term interest rates as required.
The interest rate goes down when the funds available for loan increases. Due to the decrease in the rate of interest, more people will take loan to meet their personal requirements and the organizations will take loan to meet their business requirement. This will results in to fewer saving and more spending that will increase the productivity in the economy. Increased spending increases the growth of the economy and that will increase the actual production and decrease the output gaps.
When the output gaps increases, the central bank uses the expansionary monetary policy through open market operations. The central bank purchases government securities through the private bond dealers and deposits payment into the bank accounts of the individual or organizations’ that sold the bonds. The deposits bring cash that the commercial banks hold to give loan to the common people and the business organization. Commercial banks actively wants to giver loan so that the production in the economy increases.
Another method that the central bank uses to close the output gap is changing the reserve requirement. The central bank by increasing or decreasing the reserve requirement used to control the economic condition of the country. If banks are required to hold a greater amount in reserves, then in that case the banks does not have enough fund to give loan to the common people and the business organizations. On the other hand, if the banks are allowed to hold a smaller amount of reserves then in that case it will be possible for the banks to provide loan at cheaper rate. So in order to close the output gap the banks will lower then reserve requirement. as if the reserve requirements are lowered then the commercial banks does not have to hold cash and can give more loan to the business organization which will help to increase the rate of production and close the output gap.
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