Excess Demand and Deficient Demand | class 12th | quick revision notes macro economics

Deficient demand

Deficient Demand is the state in which aggregate demand is less than the aggregate supply at full employment level in the economy.

Important Observations of Deficient demand

• A positively sloped straight line represents the value of demand for goods and services in the economy which is the sum of consumption and investment.
• The 45 degrees positively sloped straight line AS curve represents the value of supply of goods and services in an economy which is the sum of consumption and savings.
• Point E is considered as a full-employment equilibrium point because at this point AD= AS.
• Due to a decrease in investment expenditure AD curve shifts downward from AD to AD¹.
• EG indicates the Deflationary gap.
• F indicates the underemployment equilibrium.

Causes of deficient demand/deflationary gap

1. It occurs due to falling in AD
2. Fall in consumption expenditure of households, due to falling in the propensity to consume.
3. Fall in government expenditure.
4. Fall in investment expenditure, due to increase in the rate of interest or fall in expected return.
5. Fall in export due to increase in export duty.
6. Increase in import due to decrease in import duty.

Excess demand

Excess Demand is the state in which aggregate demand is more than the aggregate supply at full employment level in the economy.

Important Observations of Excess demand

• A positively sloped straight line represents the value of demand for goods and services in the economy which is the sum of consumption and investment.
• The 45 degrees positively sloped straight line AS curve represents the value of supply of goods and services in an economy which is the sum of consumption and savings.
• Point E is considered as a full-employment equilibrium point because at this point AD= AS.
• Due to an increase in investment expenditure AD curve shifts upward from AD to AD¹.
• EF indicates the inflationary gap.

Causes of Excess demand/Inflationary gap

1. It occurs due to a rise in AD
2. Rising consumption expenditure of households, due to rising propensity to consume.
3. The rise in government expenditure.
4. Rise in investment expenditure, due to decrease in the rate of interest or rise in expected return.
5. Rise in export due to decrease in export duty.
6. Fall in import due to increase in import duty.

Policies to control Excess/Deficient demand

Monetary policy

The policy of RBI is to control the money supply and the availability of credit to control excess or deficient demand along with the achievement of predetermined purposes of social and economic development.

• Repo rate- the rate at which RBI lends to commercial banks against securities or discounting a bill of exchange.
  • In case of excess demand, RBI increases repo rates, which makes loans from RBI to commercial banks relatively expensive and forces commercial banks to increase the rate of interest on loans for the public. Loans to the public will become relatively expensive and it will discourage the public from taking loans. As a result consumption and investment expenditure of the public will fall and the problem of excess demand will be solved.
  • In case of deficient demand, RBI decreases repo rate, its loan from RBI to commercial Bank relatively cheaper forces commercial banks to decrease the rate of interest on loans for the public. Loans to the public will become relatively cheaper and it will encourage the public to take loans. As a result consumption and investment expenditure of the public will rise and the problem of deficient demand will be solved.
• Open-market operations- the process of selling and purchasing government securities by RBI in an open market is known as open market operations.
  • In case of excess demand, RBI sells Government securities in the open market. When commercial banks purchase it will lead to a flow of money from commercial banks to RBI and the credit creation capacity of commercial banks will fall. As a result, consumption expenditure and investment expenditure of the public will fall and the problem of excess demand will be solved.
  • In case of deficient demand, RBI purchases Government security in the open market. If commercial banks sell it to RBI it will lead to a flow of money from RBI to a commercial bank and the credit creation capacity of the commercial bank will rise. Result consumption expenditure and investment expenditure of the public will increase and the problem of sufficient demand will be solved.
• Varying LRR-percentage of total deposits of a commercial bank which is required to keep a reserve known as LRR. It is the sum of CRR and SLR.
  • In case of excess demand, RBI increases the rate of LRR. Now commercial banks are forced to keep a larger part of total deposits as a reserve. It will reduce the credit capacity of commercial banks. As a result, consumption expenditure and investment expenditure will fall and the problem of excess demand will be solved.
  • In case of deficient demand, RBI decreases the rate of LRR. Commercial banks are forced to keep fewer total deposits as a reserve. It will increase the credit capacity of commercial banks. As a result, consumption expenditure and investment expenditure will increase and the problem of deficient demand will be solved.
• Margin requirement- the difference between the value of security and the loan granted against security is known as the margin requirement.
  • In case of excess demand, RBI increases the rate of MR. It forces commercial banks to grant a smaller amount of loan against the same security. It will reduce the lending capacity of commercial banks. As a result, consumption and investment expenditure will decrease and the problem of excess demand will be solved.
  • In case of deficient demand, RBI decreases the rate of MR. It forces commercial banks to grant more loans against the same security. It will increase the lending capacity of commercial banks. As a result, consumption and investment expenditure will increase and the problem of deficient demand will be solved.

Fiscal policy

The policy of expenditure and receipts of the government to control excess and deficient demand along with the achievement of predetermined purposes of social and economic development.

It is also known as a budgetary policy.

• Government expenditure- government incurs huge expenditure on different projects like infrastructure development, providing free services to the public, etc.
  • In case of excess demand, the government reduces expenditure especially on non-productive activities which will reduce the disposable income of the public as well as their purchasing power. As a result, consumption and investment expenditure will fall and the problem of excess demand will be solved.
  • In case of deficient demand, increases expenditure which will increase the disposable income of the public as well as their purchasing power. As a result, action and investment expenditure will increase and the problem of deficient demand will be solved.
• Taxation- Tax is a compulsory payment made by the public to the government without the expectation of direct benefit in return.
  • In case of excess demand, the government increases the rate of tax and imposes new laws, especially direct taxes. It will reduce the disposable income of the public as well as their purchase power. As a result, consumption and investment expenditure will fall and the problem of excess demand will be solved.
  • In case of deficient demand, the government decreases the rate of tax. It will increase the disposable income of the public as well as their purchasing power. As a result, consumption and investment expenditure will increase and the problem of deficient demand will be solved.