What are the different measures to control Excess Demand and Deficient Demand?
Last Updated : 17 Apr, 2023
When demand is more than what is necessary to utilise resources fully, it is called Excess Demand. In simple terms, when planned aggregate expenditure is more than aggregate supply at full employment, excess demand arises. However, when demand is not sufficient to fully utilise resources, it is referred to as Deficient Demand. In simple terms, when planned aggregate expenditure is less than aggregate supply at full employment, the situation of deficient demand arises. The different measures to control Excess Demand and Deficient Demand are:
Measures to Control Excess Demand
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The problem of excess demand arises when the current aggregate demand exceeds the aggregate demand required for full employment equilibrium. It occurs due to an increase in the money supply and easy access to credit. A change in the level of the economy's aggregate demand can be used to solve this problem. There are several ways that can be used to correct excess demand such as:
1. Decrease in Government Spending:
Government spending is a significant component of aggregate demand. This action, which the government refers to as its Expenditure Policy, is a component of its fiscal policy. Government invests a significant amount of money in developing things like highways, flyovers, buildings, railway lines, etc. A change in such spending has a direct impact on the amount of aggregate demand in the economy and helps in the management of excess and deficient demand conditions. Government spending should be as low as possible in order to manage the condition of excessive demand. Greater attention should be placed on reducing defence and unproductive expenditures, as these rarely contribute to a country's growth. Reduced government spending serves to lessen inflationary pressures in the economy by lowering the level of aggregate demand.
2. Increase in Taxes:
Taxes are the government's principal source of income. This measure is an element of Fiscal Policy and is described as the Revenue Policy of the Government. The government charges many types of direct and indirect taxes on the general public. Government Tax changes have a direct impact on the level of total demand and help in balancing excess and deficient demand in the economy. Government raises tax rates and even imposes some additional taxes during periods of excess demand. It results in a decline in total economic spending and helps in managing the condition of excessive demand.
3. Decrease in Money Supply/Accessibility of Credit:
With the help of its Monetary Policy, the Reserve Bank of India (RBI) is able to control the money supply in the economy. It is a policy used by the Central Bank of an economy to control the amount of credit or the money supply. The Central Bank (RBI) seeks to limit the availability of credit in the economy through its Monetary Policy. Two major instruments of Monetary Policy are:
(I) Quantitative Instruments
These instruments are designed to increase the total volume of credit that is in existence. The principal tools or measures are:
1. Increase in Bank Rate: Bank Rate refers to the rate at which the central bank lends money to commercial banks in order to satisfy their long-term requirements. The cost of borrowing money from the central bank increases when there is an increase in the bank rate. It drives commercial banks to raise lending rates, preventing potential borrowers from taking out loans. It helps to adjust for excess demand and lowers the amount of credit available in the economy.
2. Increase in Repo Rate: Repo Rate is the interest rate at which the central bank loans money to commercial banks to cover their short-term requirements. The central bank increases the repo rate to decrease the availability of credit during periods of excess demand. As a result, commercial banks are compelled to raise their lending rates. It prevents borrowers from taking out loans and decreases the amount of credit available in the market, which helps in reducing excess demand.
3. Rise in Reverse Repo Rate: This is the interest rate at which commercial banks can deposit excess funds with the Central Bank for a shorter period of time. The Central Bank may raise the Reverse Repo Rate to solve the problem of excess demand. It motivates Commercial Banks to deposit their excess cash with the Central Bank. It will decrease the ability of commercial banks to lend money. Due to this, investment and consumption spending may decline, which would decrease aggregate demand.
4. Open Market Operations or Sale of Securities: The selling and purchasing of securities in the open market by the central bank are referred to as Open Market Operations. It has a direct impact on the economy's money supply. When there is an excess of demand, the central bank sells securities. The reserves of commercial banks are decreased through the sale of securities. It has a negative impact on the bank's ability to extend credit and reduces aggregate demand in the economy.
5. Increase in Legal Reserve Requirements: Commercial banks are required to keep legal reserves. A rise in these reserves is a direct way to limit credit availability. Legal Reserves consist of two parts:
- Cash Reserve Ratio (CRR): It is the minimum amount of net demand and time liabilities that commercial banks are required to maintain with the central bank.
- Statutory Liquidity Ratio (SLR): This term refers to the minimum proportion of net demand and time liabilities that commercial banks must keep on hand.
The central bank raises CRR or/and SLR to reduce excess demand. It diminishes commercial banks' effective cash resources and reduces their ability to create loans. In the end, it helps in limiting the amount of credit available to the economy.
(II) Qualitative Instruments
These tools are designed to control the flow of credit. The important qualitative tools or measures are:
1. Increase in Margin Requirements: The term Margin Requirement describes the difference between the market value of the offered security and the value of the amount lent. When there is excess demand in the economy, the central bank raises the margin, which limits the ability of banks to create credit. As a result, borrowing becomes less attractive to borrowers, which reduces aggregate demand.
2. Moral Suasion (Advice to Discourage Lending): The Central Bank uses a combination of persuasion and pressure to convince other banks to act in a way that is consistent with its policy. Discussions, letters, lectures, and tips to banks are used to exercise moral persuasion. The central bank advises, requests, or persuades commercial banks not to provide credit for speculative or non-essential purposes when there is an excess of demand.
3. Selective Credit Controls (Introduce Credit Rationing): This technique involves the central bank instructing other banks to provide or refuse credit to specific sectors for a given set of purposes. In times of excess demand, the central bank imposes credit rationing to stop excessive credit flow, especially for speculative activity. It helps in removing the excessive demand.
Measures to Control Deficient Demand
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The problem of deficient demand arises when the current aggregate demand is less than the aggregate demand required for full employment equilibrium. It occurs due to a decrease in the money supply and accessibility to credit. A change in the level of the economy's aggregate demand can be used to solve this problem. There are several ways that can be used to correct deficient demand such as:
1. Increase in Government Spending:
Government spending is a significant component of aggregate demand. This action, which the government refers to as its Expenditure Policy, is a component of its fiscal policy. Government invests a significant amount of money in developing things like highways, flyovers, buildings, railway lines, etc. A change in such spending has a direct impact on the amount of aggregate demand in the economy and helps in the management of excess and deficient demand conditions. Government spending on public works should be increased as much as possible in order to manage the condition of deficient demand. This will enhance aggregate demand and help to correct the issue of deficient demand.
2. Decrease in Taxes:
Taxes are the government's principal source of income. This measure is an element of Fiscal Policy and is described as the Revenue Policy of the Government. The government charges many types of direct and indirect taxes on the general public. Government tax changes have a direct impact on the level of total demand and help in balancing excess and deficient demand in the economy. In case of deficient demand, Government decreases tax rates and even eliminates some taxes. It increases the purchasing power of people, making them capable of spending more on consumption and investment because of an increase in their disposable income. It increases overall demand and helps in managing the condition of deficient demand.
3. Increase in Money Supply/Accessibility of Credit:
With the help of its Monetary Policy, the Reserve Bank of India (RBI) is able to control the money supply in the economy. It is a policy used by the Central Bank of an economy to control the amount of credit or the money supply. During deflationary periods, the Central Bank uses its Monetary Policy to ensure easy access to credit and lower the cost of borrowing money.
(I) Quantitative Instruments
These instruments are designed to increase the total volume of credit that is in existence. The principal tools or measures are:
1. Decrease in Bank Rate: Bank Rate refers to the rate at which the central bank lends money to commercial banks in order to satisfy their long-term requirements. When there is deficient demand, the central bank decreases the bank rate to increase credit availability. It causes the market interest rate to decline, causing people to borrow more money. In the end, it causes the aggregate demand to rise.
2. Reduction in Repo Rate: Repo rate is the interest rate at which the central bank loans money to commercial banks to cover their short-term requirements. The central bank reduces the repo rate to increase the availability of credit during periods of deficient demand. It causes interest rates to decline, which encourages people to take out more credit and raises aggregate demand.
3. Decrease in Reverse Repo Rate: This is the interest rate at which commercial banks can deposit excess funds with the Central Bank for a shorter period of time. The Central Bank may decrease the Reverse Repo Rate to solve the problem of deficient demand. It discourages Commercial Banks to deposit their excess cash with the Central Bank. It will increase the ability of commercial banks to lend money. Due to this, investment and consumption spending may increase, which would increase aggregate demand.
4. Open Market Operations or Sale of Securities: The selling and purchasing of securities in the open market by the central bank are referred to as Open Market Operations. It has a direct impact on the economy's money supply. When there is a deficiency of demand, the central bank purchases securities from the market. It has an impact on the bank's ability to extend credit and increases aggregate demand in the economy.
5. Increase in Legal Reserve Requirements: Commercial banks are required to keep legal reserves. A fall in these reserves is a direct way to increase credit availability. Legal reserves consist of two parts:
- Cash Reserve Ratio (CRR): It is the minimum amount of net demand and time liabilities that commercial banks are required to maintain with the central bank.
- Statutory Liquidity Ratio (SLR): This term refers to the minimum proportion of net demand and time liabilities that commercial banks must keep on hand.
The central bank reduces CRR or/and SLR to correct deficient demand. It increases commercial banks' effective cash resources and enhances their ability to create loans. In the end, it helps in raising the amount of credit available to the economy and decreases the deficiency in demand.
(II) Qualitative Instruments
These tools are designed to control the flow of credit. The following are important qualitative tools or measures:
1. Decrease in Margin Requirements: The term Margin Requirement describes the difference between the market value of the offered security and the value of the amount lent. When there is deficient demand in the economy, the central bank reduces the margin, which increases the ability of banks to create credit in exchange for the same level of security. As a result, borrowing becomes more attractive to borrowers, which increases aggregate demand.
2. Moral Suasion (Advice to Encourage Lending): The Central Bank uses a combination of persuasion and pressure to convince other banks to act in a way that is consistent with its policy. Discussions, letters, lectures, and tips to banks are used to exercise moral persuasion. The central bank advises, requests, or persuades commercial banks to provide credit. It increases credit availability and aggregate demand.
3. Selective Credit Controls (Withdraw Credit Rationing): This technique involves the central bank instructing other banks to provide or refuse credit to specific sectors for a given set of purposes. In times of deficient demand, the central bank withdraws credit rationing and makes efforts to promote credit.
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Flexible Exchange Rate System | Meaning, Merits and DemeritsA medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country’s currency cannot be used in another country. For this purpose, the currency of one country is converted into the currency of another country, and the rate at wh
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Managed Floating Exchange Rate System : Meaning, Objectives, Merits and DemeritsA medium of exchange for goods and services is called currency, which is different from one country to another country. However, a country’s currency cannot be used in another country. For this purpose, the currency of one country is converted into the currency of another country, and the rate at wh
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Devaluation of Currency| Meaning, Reasons, Effects, Example and Critical EvaluationSometimes there arise some situations when the value of the domestic currency tends to increase drastically and faces monetary barriers. The government and the central bank intervene with some effective monetary policies for the correction of exchange rates, trade deficits, etc. One of these practic
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Depreciation of Currency : Effects, Examples and Critical EvaluationWhat is Depreciation of Currency?Currency Depreciation refers to a decrease in the value of a currency as compared to other currencies in a floating exchange rate system. Market forces of demand and supply work towards the depreciation of the currency and determine a currency depreciation rate. The
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Difference between Devaluation and DepreciationDevaluation and Depreciation are two examples of a situation when the value of domestic currency falls in terms of foreign currencies. Even though both include a reduction in the value of domestic currency, the way in which it happens is different. What is Devaluation? Devaluation means deliberately
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Balance of Payment and its Components: Capital and Current AccountUsually, government records all the transactions that arise between a country and the outside world. This record is titled Balance of Payments. Balance of Payments can also be known as the Balance of International Payments. It is a statement of all transactions between entities in one country and th
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Difference between Current Account and Capital Account of BoPBalance of Payment is a statement of all transactions between entities in one country and the outside world over a specified time period, such as a quarter or a year. It lists all interactions between residents of one country and residents of other countries that involve businesses, organizations, o
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Difference between Balance of Payment and Balance of TradeBalance of Payment and Balance of Trade are two important terms that are sometimes confused as the same. The former is a statement of all transactions between entities in one country and the outside world over a specified time period; however, the latter is the difference between the Export and Impo
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Balance of Payments: Surplus and Deficit, Autonomous and Accommodating Transactions, Errors and OmissionsA balance of payment (BoP) is a summary statement that lists all of the transactions that took place within a specific period between the resident and the outside world. The Balance of Payment indicates the extent to which a country saves enough money to cover its imports. It also reveals whether th
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Important Formulas
CBSE Previous Year Papers (2020)