PROBLEM OF DEFICIENT DEMAND AND EXCESS DEMAND

According to Keynesian, the equilibrium level of employment may or may not be the full employment level it
means equilibrium level may exceed or fall short of the full employment level. Through full employment
equilibrium is an ideal situation which every economy tries to achieve but may be unable to do so. If the
aggregate demand is less than full employment aggregate supply, the economy will only achieve under-
employment equilibrium. This situation is known as deficient demand. On the other hand, if AD is more than
AS at full employment level, this is called excess demand.

EXCESS DEMAND
It refers to the situation when aggregate demand is more than aggregate supply corresponding to the full
employment level of output in the economy.

Excess Demand Creates Inflationary Gap

Inflationary gap refers to the gap by which the actual aggregate demand exceeds the aggregate demand required
to establish full employment equilibrium. It is called inflationary because it leads to rise in the price level in the
economy.

Characteristics of Excess Demand

1. Aggregate demand exceeds aggregate supply at full employment level.
2. Excess demand implies inflationary gap.
3. In case of excess demand, economy attains over full employment equilibrium.

Observation
1. We have taken level of income/ output on OX-axis
2. We have taken aggregate demand on OY axis i.e., C +I
3. OYf is the full employment level of income and output which is determined at point E where AD curve
intersects the 45 AS line
4. EYf and OYf are equal (AD =AS) at full employment level of point E situated on AS line
5. OYf is the full employment level.
6. EYf is the required level of AD, but AYf is the actual demand at full employment level
7. E1 point indicates over full employment equilibrium while E point signifies full employment equilibrium
8. AE is the excess demand.
Therefore, we can say that excess demand generates inflationary pressure in the economy larger the
inflationary gap, greater will be the inflation in the economy. Consequently, prices will tend to rise.
Causes Of Excess Demand
1. Rise in propensity to consume : Due to increase in consumption expenditure, propensity to consume
will increase, while fall in propensity to save will create excess demand in the economy.
2. Increase in Investment : Excess demand can also arise when there is increase in investment due to
decrease in rate of interest or high business expectations.
3. Reduction in Taxes: it may occur due to increase in disposable income and consumption because of
decrease in taxes.
4. Rise in Export : Excess demand may also arise when demand for export increase due to low prices of
domestic goods or due to fall in exchange rate for domestic currency.
5. Rise in Government Expenditure : Rise in Government demand for goods and services due to increase
in public expenditure for welfare purpose in the economy may also result in excess demand.
6. Fall in imports: Decrease in import due to higher international prices in comparison to the domestic
prices may lead to excess demand
7. Deficient financing: Excess demand may occur due to increase in money supply caused by deficient
Financing
8. Increase in level of income : (7th pay comm.) Due to increase in level of income, demand will increase
and prices will go up and will create inflation in the economy.

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 Dear Money Policy
Impact of Excess Demand

1. Effect on Output : Excess Demand does not impact the level of output because economy is already at
full employment level and there is no ideal capacity in the economy. It will put excess pressure on
existing supply.
2. Effect on Employment : Economy is already operating at full employment level as there is no
possibility to increase the employment due to increase in demand (assuming there is not involuntarily
unemployment.
3. Effect in price level: Excess demand leads to rise in general prices level known as inflation when
AD > AS.

MEASURES TO CORRECT EXCESS DEMAND

In order to solve the problem of excess demand the aggregate demand has to the reduced by an amount equal to
the inflationary gap. This will bring the economy back to the full employment  m by following measure.

FISCAL MEASURES

Fiscal policy refers to the revenue and expenditure policies of the Government. It is also called as budgetary
policy of the Government. This policy reduces the level of AD in the economy by
1. Government expenditure C + I + G + (X –M)
The Government of a country incurs various expenditures
 Expenditure on public work – construction of dams, roads, bridges etc.
 Expenditure of welfare – health, education, Public welfare etc.
 Expenditure on defense of the country
 Expenditure of maintenance of law and order
 Expenditure of subsidies and transfer payments
In Case Of Excess Demand : AD > AS So there must be reduction in Government expenditure as a result
AD will decline and we can correct the situation of excess demand.
2. Increase in level of taxes: In order to reduce the level of AD, the Government can also increase taxes on richer
sections of the society when tax rate will increase, PDY[personal disposable income], will decrease, hence
demand decrease, then economy will come back to fallen employment equilibrium
3. Public borrowings.: During excess demand the Government should increase public borrowings which will
reduce purchasing power. Therefore, consumption and investment will fall.

4. Deficient financing : to correct the situation of excess demand, Government should try to avoid deficient
financing because it will put a check on additional money supply in the economy.
Thus we can say that during the time of excess demand the components of AD i.e. C + I + G + (X –M)
must be reduced to control the inflation.

MONETARY MEASURES:
Monetary policy is that policy of Government which corrects the situation of excess demand by regulating
interest rate and availability of credit in the economy.
The central bank can take several measures to correct the situation of excess demand

I. Quantitative Measures

(a) Bank Rate: Bank rate is increased which further increase the interest rate. It makes the credit costlier
and thus, reduces the demand for credit. In return less money goes to the economy so purchasing power
will be reduced. AD falls and excess demand is corrected.

(b) Open market operations: it refers to purchase and sale of Government securities in the open market
by central bank. Government securities are sold by the central bank in the open market. The central
bank withdraws additional purchasing power from the system. There will be contraction of credit. Thus,
less money will flow in the system. Purchasing power is reduced and AD falls. Hence, excess demand
is corrected

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(c) Legal Reserve Requirements. There are two types of reserves
 CRR (cash reserve ratio or minimum reserve ratio): It is the minimum percentage of deposits of
commercial bank which is kept with RBI. If CRR is increased central bank withdraws additional
purchasing power. There will be contraction of credit. Less money will flow in the system. Purchasing
power reduces and AD falls and excess demand is corrected.
 SLR (statutory liquidity ratio): It is the percentage of deposits of commercial bank every bank is
required to maintain in the form of designated fixed assets. It is increased to control excess demand as
there will be a contraction of credit. Less money will flow in the system Purchasing power reduces and
AD falls and excess demand is corrected

II Qualitative Measures

(a) Imposing Margin Requirements: a margin is the difference between market value of the security
offered by borrower against the loan and its amount Margin requirement is increased: due to this, central
bank withdraws additional purchasing power. Therefore, less money will flow in the system .So AD
falls and excess demand is corrected.

(b) Moral suasion And Direct Action: it is a combination of persuasion and pressure that the central bank
applies on other banks of order to get them to fall in line with its policy. The credit bank will presume
the commercial banks to make the credit costlier or decrease the availability of credit in order to correct
excess demand on inflationary gap.

(c) Selective Credit Control: it means the areas are selected as priority sector for either credit extension
or contraction. Contraction of credit is selected in selective areas i.e., credit rationing. Thus, we can say
that during the time of excess demand bank rate, CRR, SLR will be increased and govt. Will sell the
securities to control excess demand.

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DEFICIENT DEMAND
It refers to the situation when AD < AS corresponding to the fuller employment level of income and output in
the economy and it creates deflationary gap in the economy.

Characteristics of Deficient Demand

The main characteristics of deficient demand are as follows :
(i) In deficient demand, aggregate demand falls short of ‘aggregate supply’ at full employment.
(ii) Deficient demand implies deflationary gap.
(iii) In case of deficient demand, economy attains under employment equilibrium.

Observations
(i) X-axis measures the level of income and output.
(ii) Y-axis measures the AD (consumption + investment demand).
(iii) YF is full employment level of output and income which is determined at E point where ADF curve
(C + I) intersects the 45 AS line.
At this point: Aggregate Demand (EYF) = Aggregate Supply (OYF)
(iv) Suppose due to decrease in investment expenditure (I) AD curve shifts downwards from ADF to ADI.
AS a result, aggregate demand at full employment level becomes AYF whereas the required level of
AD at full employment level is EYF.
(v) The difference between the two (EYF – AYF) is EA which is a measure of deflationary gap.
(vi) The new AD curve (i.e., AD1) intersects the AS curve at point E1 which signifies under employment
equilibrium.
Therefore, we can say that deficient demand generates deflationary pressure in the economy larger the
deflationary gap, greater will be the deflation in the economy. Consequently, prices will tend to reduce.
In this situation, economy creates involuntary unemployment. Consequently, price will tend to decrease.

Reasons for Deficient Demand:

1. Decrease in propensity to consume: A decrease in consumption expenditure due to fall in propensity
to consume leads to deficient demand in the economy
2. Increase in taxes: AD may also fall due to imposition of higher taxes it leads to decrease in personal
disposable income as a result economy suffers from deficient demand
3. Decrease in Government expenditure: When Government reduces its demand for goods and services
due to fall in the public expenditure it leads to deficient demand
4. Fall in investment expenditure: Rise in the rate of interest or decrease in the expected rate of returns
leads to decrease in investment expenditure which reduces the AD and give rise to deficient demand
5. Rise in import: when international prices are competitively less than the domestic price may lead to
rise in import implying a cut in the AD
6. Fall in export: Export may fall due to comparatively higher prices of domestic goods or due to increase
in exchange rate of domestic currency this will lead to deficient demand.

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Cheap Money Policy
Impact of Deficient Demand:-
Deficient demand adversely affects the level of output, employment and price level in the economy.
1. Effect on output: due to the lack of sufficient AD there will be an increase in inventory stock. It will
force the firm to plan for lesser production for the subsequent period. As a result, planned output will
fall.
2. Effect on employment: deficient demand cause involuntary unemployment in the economy due to fall
in planned output.
3. Effect on general price level: deficient demand causes the general price to fall due to the lack of
demand for goods and services in the economy

MEASURES TO CONTROL DEFICIENT DEMAND:

A FISCAL MEASURES
1. Government expenditure: AD <AS, so in this case Government expenditure must be increased as
Government expenditure is a positive component of AD
AD = C + I +G + (X -M)
AD Increase = G Increase
thus, we can say that to correct deficient demand government expenditure must be increased
2. Taxes
Taxes should be decreased as Y= C + S
due to decrease in taxes, PDY increases which in term increase the purchasing power. Therefore
consumption expenditure increases. AD = C + I + G + (X - M)
AD increases, consumption expenditure new increases (AD increase = G increase)
thus, we can see that to control excess demand taxes must be increased and to correct deficient demand,
taxes must be reduced.

3. Public Borrowing
Governments reduce the public borrowings and this give greater liquidity to the public which increases
the disposable income. Therefore, consumption and investment will increase.
AD = C+I+O+(X-M)
AD increase investment increases (AD Increase = I increase)

4. Deficient Financing:
Government issue more currency and additional currency cost additional purchasing power in the
economy thus, we can say that the control excess demand, deficient financing must be reduced on to
correct deficient demand, it must be increased

B MONETARY MEASURES
I Quantitative images
(a) Bank rate: bank rate is increased which further decrease the interest rate the credit chapter and the
demand for credit return more money goes to the economy purchasing power causing extension of
credit. More money will flow in the system and purchasing power will increase and deficient demand
is corrected
(b) Open market operations: Government securities are bought by the central bank in the open market
The central bank injects additional purchasing power essential of credit more money will flow in the
system purchasing power increases and it increases deficient demand is corrected.
( c) Legal Reserve Requirements
o CRR: When CRR is decreased Central bank injects additional purchasing power. There will be
extension of credit and more money will flow in the system. Purchasing power increases and ad increase
and deficient demand is corrected
o SLR: it is decrease central bank injects additional purchasing of power. There will be extension of
credit and more money will flow in the system. Purchasing power increases and ad increases. Deficient
demand is corrected.

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II Qualitative measures
(a) Imposing Margin Requirements: margin requirements is decreased. Due to this central bank injects
additional purchasing power. Therefore, more money will flow in the system. Ad rises and deficient
demand is corrected
(b) Moral Suasion and Direct Action: the central bank will pressurize commercial banks to make the
credit cheaper on increase the availability of credit in order to collect deficient demand deflationary gap
(c) Selective Credit Control: extension of credit is selected is selective areas that is credit rationing
thus, in case of deficient demand, bank rate, CRR, SLR will be decreased and Government will purchase
its securities to increase the purchasing power to the differences deficient demand

Basis Excess Demand Deficient Demand

Meaning It is a situation when AD is more It refers to the situation when AD
than AS, corresponding to the is less than AS, corresponding to
fuller employment level. the fuller employment level in
the economy.
Inflation/Deflation It leads to inflation in the economy. It leads to deflation in the
country.
Level of It occurs due to over full
employment employment equilibrium.

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