MEANING OF EXCESS DEMAND AND DEFICIENT DEMAND
Every economy faces disequilibrium and in order to correct it , there are fiscal and monetary policy tools which can be used . in this article we would discuss , meaning of excess and deficient demand and then the measures to control excess and deficient demand . Excess demand refers to the situation where aggregate demand ( AD) is more than aggregate supply ( AS) corresponding to full employment level in the economy . On the other hand ,Deficient demand refers to the situation where aggregate supply is less than aggregate demand .Now in order to correct the problem of excess and deficient demand in the economy various steps cm be taken which are as follow-
1. CHANGE IN GOVERNMENT SPENDING
Government spending is the part of aggregate demand . If government spends a lot , the aggregate demand in the economy increases . Now the question arises , why does the aggregate demand increases ?? . To answer this , we should understand that when the government starts spending in infrastructure projects then lots of employment opportunities are generated . Due to this , the income of people increases and they start demanding more ( in simple words ) . Same is true in case of welfare spending ( like subsidy ) as well . Having understood this , suppose there is excess demand situation in the economy ( i.e. AD >AS ) . In this situation , if we want to bring economy at equilibrium (Equilibrium refers to the situation where AD = AS) then government spending should be reduced . However, in case of deficient demand , where AD < AS , government spending should be increased . Now the question arises why it should be increased ? It is so because increase in government spending will increase the aggregate demand (AD) which in turn may bring the economy back to equilibrium .
2. CHANGE IN TAXATION POLICY
Taxes are one of the main source of revenue for the government . Under the condition of excess demand ( AD> AS) , government may increase the tax burden on people . Why ?? Because increasing the tax burden on people will leave less money in hands of people to spend (disposable income reduces ) and then the demand in economy may get reduced which can bring economy back at equilibrium . On the other hand in the case of deficient demand ( AD < AS ) government may reduce the tax burden of people . Because in case of deficient demand , reduction of tax burden will increase disposable income in the hands of people . With this increased disposable income , people can increase the demand in the economy and ultimately the increase of AD will help economy move towards equilibrium .
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3. MONETARY POLICY
Central bank of every nation ( In case of India RBI is the central bank ) can use various monetary policy tools to bring the economy back to equilibrium from deficient / excess demand situation . But here arises the question ; How central bank would do this and which tools it would use ?? . To know this we would discuss various monetary policy tools used, which are as follows –
a) CASH RESERVE RATIO ( CRR )
Under CRR , every commercial bank is compulsorily required to deposit certain percentage of its NDTL ( Net demand and time liability = It is basically the deposits with banks in the form of savings account , recurring deposit account , fixed deposit , current deposit) with the central bank in the form of cash only . In a nutshell , we can conclude that if CRR is increased then it would leave banks with less money available to lend into the market . On the other hand if CRR is reduced then it would enable banks to lend more into the market . Having understood this , we can now relate it with excess and deficient demand . In case of excess demand , central bank would try to reduce the demand in economy to bring economy at equilibrium . To reduce demand , it will increase CRR. On the other hand in case of deficient demand , central bank will reduce CRR . Reducing CRR will enable commercial banks to lend more into the market ( as they would be left with more money now ).
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b) STATUTORY LIQUIDITY RATIO ( SLR )
Under SLR norms , commercial banks are bounded to maintain certain percentage of their NDTL as reserve with themselves . However , here the reserve can be maintained in the form of cash , gold , forex or government approved securities . SLR also works in the same fashion as CRR and hence has same impact on banks i.e. if SLR increased lending capacity of banks will decrease and if it is reduced then lending capacity of banks will increase . If the economy is in excess demand situation , then SLR would be increased . This will have a negative impact on banks’ lending capacity . Banks would lend less into market and hence demand in economy would decrease . On the other hand in the case of deficient demand , central bank bank will try to boost or increase demand in the economy . In order to do so , it will decrease SLR .
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c) BANK RATE
Bank rate is the rate which is used by central bank to lend money to commercial banks for long term . However , in the special context of India , Bank rate has lost its relevance in this particular aspect because RBI is no more providing long term loans to commercial banks ( generally ) .
NOTE – However Bank rate is now used to impose penalty on commercial banks . For eg . Penalty of BANK RATE + 10 % . Having understood this , we can say that in case of excess demand Bank rate will be increased and in case of deficient demand it would be decreased .
d) REPO RATE
Repo rate is basically short form of REPURCHASE RATE . Under it , commercial banks , in case of short term requirement of funds , may ask central bank to lend money ( say for 3 days ) . For this lending the central bank charges an interest and this interest is basically repo rate. Practically , against the borrowings , commercial banks place bonds / government securities as mortgage with central bank ( RBI ) . After 3 days , when banks wants to repay the loan , it purchases the same mortgaged bonds or securities at a price which is above the loan amount ( say loan amount was 100 crore , so bank will repay 102 crore and accordingly 2% is Repo Rate ) . That is why it is called as repo rate ( repurchase rate ) .
Now , suppose the economy is in excess demand situation , where demand is more than supply . So central bank would try to reduce demand in the economy in order to establish equilibrium . For this , it would increase repo rate , which will discourage banks from taking short term loans from central bank and accordingly the supply of money in economy would get reduced . It will thus reduce demand . On the other hand , in case of deficient demand repo rate would be reduced .
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d) MARGIN REQUIREMENTS
Consider a situation where Ram has gold in his house and he wants to get a loan by mortgaging it . For this he will move to bank . Bank says we will give you loan of an amount 80000 against the gold which has a value of 100000 . So here the margin is 20000 . Now let us relate this situation to understand it’s use. Under the situation of excess demand , central bank will try to reduce the demand. For this it will increase margin requirement ( say Ram will now get only 50000 against gold of value 100000 ). So in this situation people would be discouraged from taking loan . Under deficient demand , Margin requirement would be decreased to boost demand by encouraging people to take loan. However , it should be understood that all these tools are quantitative tools . There are qualitative tools as well .