Problem of Deficient Demand: Measures to correct it

Deficient Demand (Deflationary Gap)

It refers to a situation when at full employment income level, AD<AS. In other words, when the planned AD is less than AD which is required to achieve full employment equilibrium, it is called deficient demand and it gives rise to deflationary gap. When deficient demand exists, economy’s income, output and employment decline thus pushing the economy into under-employment equilibrium.

Impact of Deficient Demand

Deficient demand decreases the level of output , National Income and price level in the economy because when AD<AS, there is less demand for inputs than actually available. As a result, prices of inputs start falling. This creates deflationary situation in the economy. 

Measures to Correct Deficient Demand

Fiscal Policy Measures

Following are the measures to correct Deficient Demand/Deflationary Gap:

(a) Decrease in Taxation: When the tax rate is decreased, more money will be available in the hands of people to spend. Purchasing power will increase and credit will be expanded.   

(b) Increasing Government Spending: Government incurs expenditure on its administration and welfare schemes. An increase in expenditure will directly increase AD and help in reducing the deflationary gap. 

Monetary Policy Measures

Increasing availability of credit: Credit availability can be increased by reducing the rate of interest and increasing the lending capacity of commercial banks. following measures are taken to expand the availability of credit:

(a) Lowering the bank rate/repo rate: If the central bank lowers the repo-rate the commercial banks also lower the lending rate which increases the demand for credit. Consequently, consumption expenditure and investment expenditure tends to rise because cost of borrowing is lower.

(b) Open Market-Operations (Purchase of securities by Central Bank): In the situation of deficient demand, the Central bank buys securities. Purchase of securities injects liquidity in the market raising AD of the economy.

(c) Legal Reserve Ratio: (CRR and SLR): During deficient demand, both CRR and SLR are lowered by the Central Bank to increase credit creation by the commercial banks. The increased credit creation leads to rise in consumption and investment expenditure, pushing up the aggregate demand of the economy.

(d) Decreasing Margin Requirement: In the situation of deficient demand, the margin requirement is decreased because expansion of credit is required. As a result, rise in AD takes place in the economy.