Question

“Margin requirements are extremely helpful in correcting the situation of deflationary gap in an economy.”
Justify the given statement with valid arguments.

Hint:

In deflationary times, lowering margin requirements helps promote borrowing and spending, thereby increasing aggregate demand and closing the output gap.

Answer 1

A deflationary gap arises when aggregate demand in the economy falls short of aggregate supply at the full employment level, leading to underutilization of resources, unemployment, and slow economic growth. Margin requirement is an effective instrument of credit control used by the Central Bank to influence borrowing for investment and consumption. Here's how it helps in a deflationary situation:
Meaning of Margin Requirement: Margin requirement is the difference between the market value of the security offered for loans and the loan amount granted. A lower margin implies that the borrower has to contribute less from their own funds and can borrow more.
Encouraging Borrowing: In a deflationary situation, the central bank reduces the margin requirements. This makes it easier for borrowers to get higher loans against the same security.
Boosts Investment and Consumption: With easier access to credit, both consumers and producers are likely to spend more. Producers can invest in new projects, and consumers can buy durable goods, thus increasing overall demand.
Multiplier Effect: As aggregate demand increases, it stimulates production, generates employment, and raises income levels. This sets off a positive multiplier effect in the economy, reducing the deflationary gap.
Targeted Sectoral Impact: Margin requirements can be adjusted for specific sectors like housing or automobiles to boost demand in targeted areas of the economy.
Thus, margin requirements serve as a powerful monetary tool to tackle deflationary conditions by stimulating credit creation and reviving economic activity.