Posted by Anjali Kaur on Oct 26, 2020

Excess Demand or Inflationary Gap

Excess demand or inflationary gap refers to the situation when actual aggregate demand is more than the aggregate supply corresponding to the full employment level of the output in the economy.  Let’s understand the concept of excess demand in detail.

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Inflationary Gap

The inflationary gap is equal to the difference between the level of the aggregate demand at full employment level and actual aggregate demand, that is, the gap between actual aggregate demand and planned aggregate demand which is required to establish full employment equilibrium.

As shown below, AD and AS curve intersect each other at point E indicating full employment equilibrium whereas AD and AS intersect each other at point A indicating over employment.

Problems related to Excess Demand

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

1. Effect on Output

Excess demand does not affect the level of output because the economy is already at full employment and there is no ideal capacity in the economy.

2. Effect on Employment

There will be no change in the level of employment as the economy is already operating and there is no involuntary unemployment.

3. Effect on General price level

Excess demand leads to the rise in the general price level as actual AD is more than AS.

Measures to Correct Excess 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.

1. Reduction in Government Spending

People are in full employment, the government will reduce its spending on public work, flyovers, road construction, etc. to reduce aggregate demand.

2. Increase in Taxes

People are in full employment, there is nobody unemployed. The government will increase its taxes and government revenue all also increase with an increase in taxes, the purchasing power of the people will fall and aggregate demand will fall.

Monetary Policy

The Central bank controls the money supply and credit in the best interest of the economy. In order to do so, the Central bank makes the use of quantitative and qualitative credit control tools. These methods are also known as instruments to control the money supply in the economy.

Central banks applied quantitative and qualitative tools through its monetary policy.

Monetary Policy Tools

It includes quantitative and qualitative measures:

1. Quantitative Measures

The quantitative measures regulate the total quantity of credit in the economy. Such measures affect the economy as a whole and are non-discriminatory in character. 

a. Bank rate

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

The rate at which the central bank of a country lends money to the commercial banks to meet their long term needs.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the bank rate is increased which further increases the lending rate of commercial banks. It makes the credit costlier, demand for credit decreases, less money will go to the economy, purchasing power is reduced, aggregate demand in the economy falls and excess demand is corrected.

b. Repo rate

The rate at which the central bank of a country lends money to the commercial bank to meet their short-term need.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the central bank will increase the repo rate which will make borrowing by commercial banks costly. So, when the repo rate is increased, banks are also forced to raise their lending rate. It made the credit costlier, demand for credit reduces, less money goes to the economy. The purchasing power is reduced, aggregate demand falls and excess demand is corrected.

c. Reverse Repo Rate

The rate at which commercial banks lends money to the central bank is called the reverse repo rate.

If there is inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the reverse repo rate is increased it encourages commercial banks to park their surplus funds with the central bank. This has a negative effect on the lending capacity of the commercial banks. Demand for credit will reduce, less money will go to the economy, aggregate demand falls and excess demand is corrected.

d. 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 inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, government securities are sold by the central bank in the open market. The central bank withdraws additional purchasing power. There will be a contraction of credit, less money flows in the economy, purchasing power in the economy reduces, aggregate demand falls and excess demand gets corrected.

e. Legal Reserve Ratio

LRR or variable reserve ratio is that fraction of the deposits of commercial banks, which is legally compulsory for them to maintain on account of cash reserve ratio and statutory liquidity ratio.

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 inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, CRR is increased to control excess demand. The central banks withdraw additional purchasing power, there will be a contraction of credit, less money will flow into the economy. The purchasing power in the economy reduces, aggregate demand falls and the excess demand is corrected.

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 inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, SLR is increased to control excess demand. The central bank withdraws additional purchasing power in the economy. There will be a contraction of credit, less money will flow in the economy, purchasing power in the economy falls, aggregate demand decreases, and excess demand is corrected.

2. Qualitative measures

It refers to selective credit control that focuses on the allocation of credit in different sectors. It includes the following:

a. 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 inflation or extra money supply in the economy, it implies excess demand for money in the economy. In such a case, the margin requirement is increased, to correct excess demand. The central bank withdraws additional purchasing power, there will be a contraction of credit, less money will flow into the economy. The purchasing power in the economy falls, aggregate demand decreases, and excess 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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