EXCESS DEMAND AND DEFICIENT DEMAND

Excess demand- refers to the situation when aggregate demand (AD) is more than
the aggregate supply (AS) corresponding to full employment level of output in the
economy . Excess demand gives rise to an inflationary gap . Inflationary gap refers
to the gap by which actual aggregate demand exceeds the aggregate demand
required to establish full employment equilibrium .

Reasons for excess demand –

1. Rise in the propensity to consume – because of increase in consumption
exp due to rise in the propensity to consume or fall in propensity to save .
 2. Reduction in taxes – it may also occur to increase in disposable income and
consumption demand because of decrease in taxes.
3. Increase in govt. expenditure – rise in govt. demand for g/s due to increase
in public expenditure will also result in excess demand.
4. increase in investment - due to decrease in rate of interest or increase in
expected returns.
5. Fall in imports – decrease in imports due to higher international prices in
comparison to domestic prices may also lead to excess demand .
6. Rise in exports – when demand for exports increases due to comparatively
lower prices of domestic g/s or due to decrease in the exchange rate for
domestic currency .
7. Deficit financing – excess demand may due to increase in the money
Supply caused by deficit financing .
Impact of deficit financing – excess demand is not a desired situation because it
does not lead to any increase in level of aggregate supply as the economy is
already at full employment level . Excess demand has the following effect on
output , employment and general price level
1. Effect on output : excess demand does not affect the level of output
because economy is already at full employment level and there is no idle
capacity in the economy .
2. Effect on employment : there will be no change in the level of employment
as the economy is already operating at full employment and there is no
involuntary unemployment .
3. Effect on general price level : excess demand leads to rise in the general
price level ( known as inflation ) as aggregate demand is more than supply.

Deficit Demand – refers to the situation when aggregate demand (AD ) is

less than the aggregate supply (AS) corresponding to full employment level
of output in the economy .
Reasons for Deficit Demand –
1. decrease in propensity to consume – A decrease in consumption
expenditure due to fall in the 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 disposable income and as a result, the economy suffers
from deficient demand.
3. Decrease in govt. expenditure – when govt. reduces its demand for g/s due
to fall in public expenditure it leads to deficient demand.
4. Fall in investment expenditure – increase in the rate of interest or fall in the
expected returns leads to decrease in the investment expenditure . It
reduces the AD and gives rise to deficient demand.
5. Rise in imports- when international prices are comparatively less than the
domestic prices, then it may leads to a rise in imports, implying a cut in the
aggregate demand.
6. Fall in exports – exports may fall due to comparatively higher prices of
domestic goods or due to increase in the exchange rate for domestic
currency. This will leads to deficient demand.

Impact of Deficient Demand- deficient demand in the economy due to its

inflationary nature.It create adversely affects the level of output ,
employment and price level in the economy.
1. Effect on output – due to lack of sufficient aggregate demand , there will
be an increase in the inventory stock. It will force the firms to plan for
lesser production for the subsequent period. As a result, planned output
will fall.
2. Effect on employment – deficient demand causes inventory
unemployment in the economy due to fall in the planned output.
3. Effect on general price level- deficient demand causes the general prices
to fall due to lack of demand for g/s in the economy.

Measures to correct excess demand –

1. Decrease in govt. spending- It is a part fiscal policy . Government
spends huge amount on infrastructural and administrative activities.
To control the situation of excess demand , govt.should be placed to
reduce its expenditure to the maximum possible extent. More
 emphasis should be placed to reduce expenditure on defense and
unproductive works as they rarely help in growth of a country .
Decrease in govt. spending will reduce the level of aggregate
demand in the economy and helps to correct inflationary pressures
in the economy
2. Decrease in the availability of credit – RBI aims to reduce availability
of credit in the economy through its monetary policy .
1. Quantitative Instruments –
1.increase in bank rate- during excess demand ,central bank
increases the rate, which raises the cost of borrowing from the
central bank.It forces the commercial banks to increase their
lending rates, which discourages borrowers from taking loans. It
reduces the availability of credit in the economy and helps to
correct excess demand.
2. open market operation (sale of securities )- during excess demand
, central bank offers securities for sale. Sale of securities reduces the reserves of
commercial banks. It adversely
Affects to create the bank’s ability to create credit and decrease
the level of aggregate demand in the economy.
3.Increase in legal reserve requirements (LRR) : Commercial banks are
obliged to maintain legal reserves . An increase in such is a direct
method to reduce the availability of credit .To correct excess demand
central bank increase CRR/ SLR.

2.Qualitative Instruments
1. increase in margin requirements – when economy suffering from
excess demand , central bank increases the margin , which restricts the
credit creating power of banks. Borrowers find it less attractive to
borrow money and it decreases the level of aggregate demand.
2. moral suasion (advise to discourage lending )- during excess demand ,
the central bank advises, requests or persuades the commercial banks
not to advance credit for speculative or non – essential activities . It
helps to reduce availability of credit and aggregate demand.
3. selective credit controls – during excess demand , the central bank
introduces rationing of credit in order to prevent excessive flow of
credit. It helps to wipe off the excess demand.

Measures to correct deficient demand-

1. Increase in govt. spending- during deficient demand the govt. should
increase expenditure on public works like construction of roads ,
flyover, building etc. with to provide additional income to people.This
Will the aggregate demand and will help to correct the situation of
deficient demand.
2. Increase in availability- during deflationary situations , the central
bank aims to ensure easy availability of credit and reducing cost of
borrowing money through its monetary policy .
A - Quantitative instruments
1. Decrease in bank rate – during deficient demand the central
bank starts purchasing securities from the open market. It
increases the money supply and enhances the purchasing
power capacity and increases level of aggregate demand in the
economy.
2. Decrease in legal reserve requirement – commercial bank are
obliged to maintain legal reserves . Decrease in such reserves
helps to raise the availability of credit. To correct
The deficient demand , the central bank decreases CRR and
SLR . It increases the amount of effective cash resources of
commercial banks and enhances their credit creating power. It
will raise the level of borrowing and helps to maintain the
deficiency in demand .
B – Qualitative instruments
1. Decreases in margin requirements : during deficient demand
central bank reduces the margin which enhances the credit
creating power of banks.With decreases in margin, commercial
banks can grant more loans than before against the same
amount of security . It encourages the borrowers to borrow
 more money and raises availability of credit and aggregate
demand.
2. Moral suasion (advise to encourage lending ) – during deficient
demand the central bank advises request or persuades the
commercial banks to encourages credit . It helps to raise
availability of credit and aggregate demand .
3. Selective credit controls (withdraw credit rationing ) – during
deficient demand the central bank withdraw rationing of
credit and make efforts to encourage credit.

Excess and Deficient Demand in three sector economy – In a

three sector economy with households, firms and govt. AD is
the sum total of consumption (C ) investment (I) and govt.
expenditure (G ) . With introduction of govt. sector, the new
AD curve (C +I +G) lies above old AD curve (C+ I ).

Remedy for Deficient Demand – the deficient demand can be

corrected by increasing the aggregate demand by an amount
equal to the deflationary gap. In order to correct this
deflationary gap govt. needs to use its fiscal measures of
increasing expenditure. When govt. expenditure is increased,
the new level of aggregate demand is AD corresponding to a
higher level of govt.expenditure. New curve AD is sufficient to
keep the economy at full employment equilibrium .

Remedy for Excess Demand – to correct the problem of excess

Demand, the aggregate demand has to be reduced by an
amount equal to inflationary gap.Govt. needs to use its fiscal
measures of reducing expenditure .Decrease in govt.
expenditure will reduce aggregate demand and remove the
inflationary gap.