Chapter 10-11 PROBLEM OF DEFICIENT AND EXCESS DEMAND - Chapter Notes, class 12 - Commerce PDF Download

PROBLEM OF DEFICIENT AND EXCESS DEMAND

DEFICIENT DEMAND ( DD ) :: It refers to situation where Aggregate demand is short of (less than ) Aggregate Supply corresponding to Full Employment in the economy

 It is level of demand which is insufficient to eliminate involuntary unemployment

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Point ‘E’ is equilibrium level as AD = AS at full employment level (“OY” ). AD1 is country’s level of
demand which intersect AS at ‘U’ corresponding to “OY1” level of income.Thus
“U” = Under employment equilibrium
“YY1”= Involuntary Unemployment
“EG” = DEFLATION GAP or Deficient Demand

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IMPLICATION / EFFECT / CONSEQUENCE OF DEFICIENT DEMAND

(1) INVOLUNTARY UNEMPLOYMENT :: The level of AD happen to be short of F.E.L. and this will result in increase in unsold stock with producers and will force them to plan lesser production for subsequent years .This will result in reduction in investment and correspondingly reduction in output / income / employment in the economy
(2) UNDEREMPLOYMENT EQUILIBRIUM :: The level of AD fails to cope with the level of AS upto the point of full employment in the economy and intersect AS at point ‘U’ and thus take country from Full employment level to under employment level which means some resources will remain unutilised and unemployed
(3) PRICE FALLS :: only to clear the undesired and unplanned stock the producer may reduce price .
DEFLATION GAP AND MEASUREMENT :: Deflation gap is difference between

(i) Desired / Required level to AD to establish full employment equilibrium

(ii)Actual level of AD in the country

 It is measure of deficiency of Aggregate Demand i.e when AD < AS corresponding to F.E.L and always related to involuntary unemployment

EXCESS DEMAND (ED) :: It refers to situation where Aggregate demand is in excess of (more than ) Aggregate Supply corresponding to Full Employment in the economy

 It is level of demand which is sufficient to cause rise in price

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Point ‘E’ is equilibrium level as AD = AS at full employment level (“OY” ). AD2 is country’s level of
demand which interest AS at ‘F’ .Thus

“F” = Beyond Full employment equilibrium

“FE” = INFLATION GAP or Excess Demand

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IMPLICATION / EFFECT / CONSEQUENCE OF EXCESS DEMAND

(1) RISE IN PRICE :: The level of planned AD happens to exceed F.E.L .Since output / employment cannot be increased beyond F.E.L, as more resources are not available and technology is assumed to be constant thus Excess Demand put pressure on available goods and services and this makes Price to increase(inflation).
(2) BEYOND FULL EMPLOYMENT EQUILIBRIUM :: The level of AD surpasses the level of AS (total production) even when there is full capacity production .This drive the economy into situation of increase in market price of good and services.
INFLATION GAP AND MEASUREMENT :: Inflation gap is difference between
(i) Actual level of AD in the country
(ii) Desired / Required level to AD to establish full employment equilibrium

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INFLATION GAP = Actual AD - AD for establishing F.E.L = “FY” - “EY” = “FE”

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 It is measure of Excess of Aggregate Demand i.e when AD > AS corresponding to
F.E.L and always related to rise in price

MEASURE TO CORRECT EXCESS DEMAND AND
DEFICIENT DEMAND

Situation of excess demand and deficient demand both refers to economic instability and thus causes need for government interference to tackle measure to remove them.Broadly there are two policy / measures
(1) FISCAL POLICY :: relating to government revenue and government expenditure
(2) MONETARY POLICY :: relating to supply , availability and cost of capital .It is also known
as BANK POLICY
FISCAL POLICY :: It refers to government budgetary policy related to government revenue and government expenditure for the purpose of removing economic instability i.e. correcting deficient demand and excess demand.

FISCAL POLICY & DEFICIENT DEMAND (OR DEFLATIONARY GAP)

(1) INCREASE IN PUBLIC EXPENDITURE :: Acc. to keynes it is the most important measure to raise level of AD in the economy..Thus investment expenditure on parts namely .............. should be increased which will further cause income to increase proportionally more due to multiplier effect.The rise in level of income in the country will cause level of AD to rise. This policy is also called as PUMP-PRIMING in the system.

(2) INCREASE IN DEFICIT FINANCING :: It refers to printing or issuing more currency and results in increase in supply of money in the country and also the purchasing power of the people .High purchasing power means more demand for goods and services

(3 - 4) DECREASE IN TAXES AND REDUCTION IN PUBLIC BORROWING :: Less taxes and less borrowing by the govt. means household and firms are left with more disposable income .This will encourage them to spent more on consumption and investment .Consequently demand in the economy as a whole will increase

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Thus policy of DEFICIT BUDGET ( more exp. and less revenue) is followed in situation of
DEFICIENT DEMAND or DEFLATIONARY GAP)

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FISCAL POLICY & EXCESS DEMAND (OR INFLATION GAP)

(1) DECREASE IN PUBLIC EXPENDITURE :: Acc. to keynes it is the most important measure to decrease the level of AD in the economy..Thus investment expenditure on parts namely .............. should be decrease which will further cause income to decrease proportionally more due to multiplier effect.The fall in level of income in the country will cause level of AD to fall
(2) REDUCE DEFICIT FINANCING :: It refers to printing or issuing less currency and results in decrease in supply of money in the country and also the purchasing power of the people . Low purchasing power means less demand for goods and services
(3-4) INCREASE IN TAXES AND INCREASE IN PUBLIC BORROWING :: more taxes and more borrowing by the govt. means household and firms are left with less disposable income .This will lead to spending of less on consumption and investment . Consequently demand in the economy as a whole will decrease

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Thus policy of SURPLUS BUDGET ( LESS exp. and MORE revenue) is followed in situation
of EXCESS DEMAND (or INFLATION GAP)

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MONETARY POLICY // CREDIT POLICY // BANK POLICY :: It is that policy by which Government of a country and Central Bank (RBI in india) controls the
(i) Supply of Money and thus Availability of Credit
(ii) Cost of Credit for the purpose of removing economic instability i.e. correcting deficient demand and excess demand.

QUANTITATIVE INSTRUMENT

(1) BANK RATE :: Bank rate is the rate at which the central bank of a country (RBI in case of India) lends money to commercial banks by rediscounting approved B/E or other commercial papers
It is also known as DISCOUNT RATE
Thus changes in bank rate has the effect of changing the cost of securing fund from Central bank

(2) REPO (REPURCHASE) RATE : Repo rate is the rate at which the commercial banks borrow from Central Bank for a short priod by selling their financial securities to Central bank
 Thus thecentral bank advances loans against approved securities

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NOTE : (a) Bank rate is often higher than the repo rate.
(b) It is repo rate (not the bank rate), which is often used as a policy instrument
to control the supply of money.

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(3) CHANGE IN MINIMUM CASH RESERVE RATIO :: It refers to minimum percentage of Bank’s total deposit which is required to be kept with central Bank in form of cash
E.g if Minimum Cash Reserve Ratio is 10 % and total deposit of a certain Bank is Rs.100 crore, then Reserve amount will be Rs.10 crore and bank can extend loan upto 90 crore

(4) CHANGE IN LIQUIDITY RATIO :: It refers to fixed percentage of Bank’s assets which is required to be maintained by every bank in form of CASH OR OTHER LIQUID ASSETS, called liquidity ratio.This ratio is also called STATUTORY LIQUIDITY RATIO(SLR)

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THREE COMPONENTS OF SLR
Cash
Gold
Unencumbered and Approved securities

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SPECIAL POINT :: While estimating CRR inter - bank loans are not included in total deposit of bank where as in SLR , these are included .
Since both are determined by RBI individually , therefore each or both MAY be called as Legal reserve ratio

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(5) OPEN MARKET OPERATION :: It refers to sale and purchase of government securities by Central Bank in the open market.

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(6) REVERSE REPO RATE :: This is exact opposite of Repo rate. Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from commercial banks.

RBI makes use of this tool when it feels that there is excess money supply in the banking system. Banks are always happy to lend money to RBI as their money is in safe hands with a good interest.

An increase in Reverse repo rate induces the banks to transfer more funds to RBI due
to attractive interest rates.

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DIFFERENCE BETWEEN BANK RATE & REPO RATE :: Both bank rate and repo rate refer to the rate of interest at which commercial banks can raise loans from the RBI. However, there are some differences, as under :

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QUALITATIVE INSTRUMENT ( SELECTIVE CREDIT CONTROL )
SELECTIVE CREDIT CONTROL :: It refers to discriminatory policy of Central Bank in favour or against certain sectors of the economy.
In case of priority sector like health and education flow of credit is encouraged with a view to stimulate the level of economic activity in these sectors.This is POSITIVE APPLICATION OF SELECTIVE CREDIT CONTROL
In case of non- priority sector like credit for speculation (e.g storage of foodgrain) at times of inflation flow of credit is discouraged and restricted .This is NEGATIVE APPLICATION OF SELECTIVE CREDIT CONTROL
(1) RATIONING OF CREDIT :: It refers to fixation of credit quotas for different business activities.The commercial bank cannot exceed the quota limit while giving loan.
In case of excess demand quotas are reduced to control flow of credit in market particularly for speculative activities
In case of deficient demand quotas are increased to increase flow of credit in market

(2) DIRECT ACTION :: Central bank takes direct action in case commercial bank donot
comply with their guidelines.It includes derecognisition of a member bank from country’s
banking system
(3) MORAL SUASION :: It refers to combination of “PERSUASION” AND “PRESSURE” by central bank to make the member bank follow its directives with the view of controlling credit and removing economic instability
Moral suasion is exercised through discussions, letters, speeches and hints to banks. The Reserve Bank frequently announces its policy position and urges the banks to cooperate in implementing its credit policies. Generally, central bank succeeds in convincing the banks as it acts as their lender of last resort.
However, NO PUNITIVE ACTION IS TAKEN in case they do not follow the advice or request.

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Moral suasion can be used for both quantitative as well as qualitative credit control.

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(4) CHANGE IN MARGIN REQUIREMENT :: It refers to difference between current value of security offered for loans and value of loan granted.
Suppose a person mortgages his house worth Rs.100 lakh and gets a loan of Rs.80 Lakh
then MR is 20% . In other words bank is allowed to give loan only upto 80% of value of
security
RBI may prescribe different margins for different type of borrowers against the security of the same commodity.
Margin is necessary because if a bank gives a loan equal to the full value of security, then
bank will suffer a loss in case of fall in price of security.

 CHECK YOUR CONCEPT ’S
(Q1) Whether the following changes by the Reserve Bank will increase the money supply or decrease the money supply ?

(i) Rise in Bank rate.
(ii) Purchase of Securities in the open market.
(iii) RBI increases the margin from 20% to 30%.
(iv) RBI reduces the Cash reserve ratio.

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(Q2) Name the monetary measure indicated in the following statements. Also indicate, whether the following measures will be adopted during excess demand or deficient demand.
(i) RBI starts selling Government securities to the public.
(ii) Instead of 80%, now 90% of the security amount will be given as loan.
(iii) It resulted in increase in interest rate charged by commercial bank from the borrowers.
(iv) RBI advised SBI to stop advertising for home loans in order to discourage lending.
(v) Central bank reduces the amount of time and demand deposits required to be kept as reserves.
(vi) RBI instructed not to advance loans to people with income above 5 lakhs per annum.

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