Posted by Anjali Kaur on Oct 22, 2020

Deficient demand

Deficient demand means that the aggregate demand is less than the planned aggregate demand. Let’s understand the concept of deficient demand in detail.

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Important Terms

1. Ex-ante Investment

It refers to planned investment corresponding to the different income in an economy.

2. Ex-post Investment

It refers to actual investment in the economy during a period of 1 year.

3. Induced Investment

It refers to the investment which changes as the level of income changes in the economy.

4. Ex-ante Savings

It refers to planned savings corresponding to the different levels of income in an economy.

5. Ex-post Savings

It refers to the actual savings in the economy during the period of 1 year.

6. Ex-ante Aggregate Demand

It means the planned aggregate demand corresponding to the different levels of income in an economy.

7. Ex-post Aggregate Demand

It refers to the actual aggregate demand in an economy during a period of 1 year.

8. Ex-ante Aggregate Supply

It refers to the planned aggregate supply of the goods and services corresponding to the different income levels in an economy.

9. Ex-post Aggregate Supply

It means actual aggregate supply in an economy during the period of 1 year.

10. Full Employment

It refers to a situation when all those who are able to work and are willing to work at an existing wage are getting work or employment.

11. Involuntary Unemployment

It refers to a situation when people are willing to work at an existing wage rate but are not getting work due to the lack of demand in the market.

Disequilibrium Concept

It refers to a situation when the economy is not in equilibrium that is when there exist 2 situations:

  1. Deficient Demand ( AD < AS )
  2. Excess Demand ( AD > AS ) This I will discuss in the next post.

Deficient Demand

It refers to the situation when AD < AS corresponding to the full employment level of output in the economy. When the actual level of AD is less than the full employment level of AD then that gap between full employment AD and actual AD is known as the deflationary gap.

The deflationary gap measure the size of the deficient demand. As shown in the diagram AD and AS intersect each other at point E which indicates full-employment equilibrium, but actual AD that is, AD intersects AS at point E1 indicating underemployment. The gap between actual AD and planned AD is EBE1 is known as the deflationary gap.

Problems of deficient demand

Problems or consequences or result or the impact of deficient demand :

1. Effect on Output

Due to a lack of sufficient AD, there will be an increase in the inventory or stock. This will force the firms to reduce production level which will lead to lower output.

2. Effect on Employment

Deficient demand causes involuntary unemployment in the economy.

3. Effect on General Price Level

Deficient demand causes the general price levels to fall in the economy due to a lack of demand for goods and services in the economy.

Measures to correct Deficient Demand

To correct deficient demand we have fiscal policy and monetary policy:

Fiscal Policy

Fiscal policy refers to the revenue and expenditure policy of the government to control the situation of inflation and deflation in the economy.

To control deficient demand, the government will adopt the following tools:

1. Increase in Government Spending

The increase in government spending is an expenditure policy. If the economy is suffering from the deflationary gap, the government should increase its expenditure on public works such as road construction, flyovers, etc. with a view to providing additional income to the people. This will increase AD and the situation of deficient demand gets corrected.

2. Reduction in Taxes

This is a revenue policy of the government so, in a situation of a deflationary gap, the government should reduce the rate of taxes which will increase the purchasing power of the people. This will help in increasing people spending on consumption and investment. Finally, it will raise the level of AD and deficient demand will get corrected.

Monetary Policy

Monetary policy refers to the policy of controlling money supply in the economy by the Central bank. The central bank has a quantitative and qualitative instrument to control the money supply.

1. Bank rate

Bank rate or discount rate means the same in case of credit control by the central bank.

If there is deflation in the economy or less money supply, it implies deficient demand for money in the economy. In such a case, the bank rate is reduced, it decreases the lending rate by commercial banks, it makes the credit cheaper, demand for credit increases. More money flows to the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

2. Open market Operation

It refers to the purchase and sale of government securities in the open market (public and commercial banks) by the central bank.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, by purchasing the government securities, the central bank injects additional purchasing power in the system which expands credit. More money flows in the economy, purchasing power increases, aggregate demand rises and deficient demand is corrected.

3. Cash Reserve Ratio

It is also known by the minimum reserve ratio. CRR is the minimum percentage of deposits of commercial banks (Net demand and time liabilities) which is kept in the form of cash with the central bank.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, CRR is decreased to control the deficient demand. The central banks inject additional purchasing power in the economy which expands credit demand. Money flows in the economy, purchasing power increases, aggregate demand rises and deficient demand is corrected.

4. Statutory Liquidity Ratio

SLR is the minimum percentage of deposits of commercial banks (Net demand and time liabilities) which every bank is required to maintain with itself in the form of liquid assets like current account balances.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, SLR is decreased to control of deficient demand. The central bank injects additional purchasing power in the economy which expands the demand for credit. Money flows in the economy, purchasing power increases, aggregate demand increases, and deficient demand is corrected.

5. Margin Requirement

A margin is a difference between the market value of the securities offered by the borrowers against the loan and the amount of loan granted. Margin requirement also means the discount fixed by the central bank on the assets which are kept as securities to the commercial banks.

For example, the margin requirement is 20%, then the bank is allowed to give loans only up to 80% of the value of the securities.

If there is deflation in the economy or less money supply in the economy, it implies deficient demand for money in the economy. In such a case, the margin requirement is reduced to correct deficient demand. The central bank injects additional purchasing power in the system which expands credit, more money flows in the economy. The purchasing power in the economy increases, aggregate demand increases, and deficient demand is corrected.

Thank You for reading.

You can read the related post on macroeconomics:

Working of the Investment

Investment Multiplier

Types of Employment Equilibrium

Concept of Short-Term Equilibrium

Aggregate Supply

Aggregate Demand

Introduction To Money

Central bank and its function

Process of credit creation

Precautions while calculating the national income

Real and nominal GDP

National income

National income formula list

Value-added method

Income method

Expenditure method

GDP and welfare

Domestic territory and national residents

Circular flow of income

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