Problem of Excess Demand: Measures to correct it

The potential level of National Income is the full employment. It is the level at which all the resources of an economy are fully and efficiently employed. Every economy wants to achieve full employment.

The objective of full employment is achieved when AD=AS at this level of employment. The gap between Ad and As at full level of employment is called Income gap. Various measures can be taken to reduce this gap.

Excess Demand (Inflationary Gap)

Excess demand refers to a situation when Aggregate demand is in excess of aggregate supply corresponding to full employment in an economy. In other words, demand is said to be ‘excess’ when it is more than what is required for the fuller utilization of resources in the economy.

Since AD is not equal to AS in the case of excess demand, the economy is not in equilibrium. Excess demand brings inflation in the economy. Therefore, excess demand is also called “inflationary gap.”

Impact of Excess Demand

When AD>As at full employment it means the buyers are planning to buy more than the maximum output sellers are planning to produce without increasing employment. The producers over-utilize the resources to meet the excess demand. As a result, demand for input increases leading to rise in prices of input cost. In turn, the producers raise prices of products they produce. This leads to inflation.

Measures to Correct Excess Demand

The situation of excess demand arises when at full employment level of income AD is not equal to AS. This situation can be corrected by influencing AD in such a manner that it becomes equal to AS. The overall objective is to achieve full employment equilibrium.

Government can influence AD by taking fiscal and monetary measures. Government takes fiscal measures through budget formation and monetary measures through Central Bank.

Fiscal Policy Measures

Fiscal Policy Measures refer to the use of the legal power of the government to tax and spend in order to achieve economic objectives. Imposing taxes affects purchasing power of people and changing Government Expenditure (G component of AD) affects the Aggregate Demand. Both these fiscal policy instruments considerably affect the Aggregate demand of the economy.

Following are the measures to correct Excess Demand/Inflationary Gap:

(a) Increase in Taxation: In situation of excess demand, taxes should be increased which reduce the disposable income that people may have spent in order to cut down the demand on consumption and investment.

(b) Reducing Government Spending: It is fiscal measure. Government incurs expenditure on its administrative and welfare functions such as expenditure on public works program, on education, on defense, police, sanitation, courts, relief measures and expenditure on various types of subsidies given to the producers for encouraging production. This expenditure is a component of AD. A reduction in this expenditure will directly reduce AD and help in removing the inflationary gap. 

Monetary Policy Measures

Monetary Measures refer to the exercising of power by the Central Bank of the country to influence money supply to achieve economic objective:

Money supply in a country is a sum of (i) currency with public and (ii) demand deposit with the commercial banks

Central Bank has the power to influence both as change in money supply influencing AD. One way of influencing demand deposit is by regulating the availability of credit:

To correct excess demand the need is to reduce availability of credit. Credit means loans. When somebody takes a loan, he has to pay interest. Payment of interest is a cost of borrow. Higher the interest, higher the cost and low the borrowing. Most borrowings are for making expenditure on consumption and investment. Both are component of AD. Demand for investment and consumption can be reduced by increasing the rate of interest. This in turn reduces AD. 

Central Bank has the power to influencing rate of interest. It has the power to restrict the lending capacity of the commercial banks. The methods which are followed are:

(a) Increasing Bank Rate /Repo rate: Both bank rate and Repo rate are the rate at which the central bank lends money to commercial banks. To correct the situation of excess demand, bank rate and repo rate is increased by RBI. As a follow up action, the market rate of interest is also raised by commercial banks. Cost of borrowing rises. It lowers the demand for credit lending. Consequently, consumption expenditure and investment expenditure go down implying cut in AD which in turn brings down the inflation.

(b) Open Market Operations: In the situation of excess demand, RBI starts selling securities to soak the liquidity in the market. With less money in the hands of people, Aggregate demand reduces and eases the inflationary pressure.

(c) Legal Reserve ratio: The central bank has power to ask commercial banks to keep certain minimum percentage of deposit as a reserve called Legal Reserve which has two components: CRR and SLR.

(d) Cash reserve ratio: (CRR): The minimum percentage of deposits   to be kept with RBI by the commercial banks is called Cash Reserve Ratio (CRR). CRR is increased to correct situation of excess demand. A rise in CRR reduces the reserves with commercial banks which reduces their capacity to lend and create credit. This causes reduction in the availability of credit in the market.

(e) Statutory Liquidity Ratio: (SLR): The minimum percentage of deposits to be kept by a commercial bank with itself is known as SLR and it is fixed by Central Bank from time to time. It is actually the ratio between liquid assets and total deposits of the commercial bank. During the situation of excess demand SLR is increased which reduces the credit creation capacity of the commercial banks as well as reduces AD. 

(f) Increasing margin Requirement: In the situation of excess demand, the flow of credit is to be restricted and margin requirement of loan is increased. The higher the margin requirement, less is the amount that can be lent to the prospective borrowers.