Chapter 9: Excess Demand & Deficient Demand

Full Employment vs Underemployment Equilibrium

The Keynesian model shows that an economy can settle at equilibrium at any level of output — not necessarily at full employment. Three situations are possible:

• Full Employment Equilibrium: AD = AS exactly at the full employment level of output. No gap exists. This is the ideal situation.
• Underemployment Equilibrium (Deficient Demand): AD is below the level needed for full employment output. The economy settles at a low-income equilibrium with unemployment. Leads to a deflationary/recessionary gap.
• Over-full Employment (Excess Demand): AD exceeds the level consistent with full employment output. Since real output cannot rise beyond full employment, the excess demand causes prices to rise. Leads to an inflationary gap.

Inflationary Gap (Excess Demand)

An inflationary gap arises when actual Aggregate Demand exceeds the Aggregate Demand needed to achieve full employment output.

Definition: The inflationary gap is the amount by which actual AD exceeds the AD required for full employment equilibrium.

Causes of excess demand:

• Increase in money supply (excess liquidity in the economy)
• Reduction in taxes → higher disposable income → higher consumption
• Rise in autonomous investment or government expenditure
• Reduction in imports or rise in exports (higher net exports)

Effect: Since the economy is already at full employment, output cannot increase. The excess demand bids up prices → demand-pull inflation. Real output stays the same but nominal GDP rises.

Measuring the gap: Inflationary gap = Actual AD – AD required at full employment. Note: the gap is measured in terms of the excess spending, not the difference in income levels.

Deflationary Gap / Recessionary Gap (Deficient Demand)

A deflationary gap (also called recessionary gap) arises when actual Aggregate Demand falls short of the Aggregate Demand needed to achieve full employment output.

Definition: The deflationary gap is the amount by which actual AD falls short of the AD required for full employment equilibrium.

Causes of deficient demand:

• Reduction in money supply or tightening of credit
• Rise in taxes → lower disposable income → lower consumption
• Fall in investment (pessimistic business expectations)
• Fall in government expenditure (fiscal contraction)
• Rise in propensity to save (paradox of thrift)

Effect: Producers find unsold inventories piling up → cut output → reduce employment → income falls → recession and unemployment.

Measuring the gap: Deflationary gap = AD required at full employment – Actual AD. Alternatively: Gap in income (ΔY) × MPS = Gap in AD (since ΔY = Multiplier × ΔAD, so ΔAD = ΔY × MPS).

Measures to Correct Excess Demand (Inflationary Gap)

To reduce excess demand, the government and RBI need to reduce AD by withdrawing money from the economy:

Fiscal (Government) Measures:

• Reduce Government Expenditure: Less public spending → less income injected into the economy → AD falls.
• Increase Taxes: Higher direct taxes (income tax) → lower disposable income → lower consumption → AD falls.
• Reduce Transfer Payments: Less social spending → less income in households → lower consumption.
• Surplus Budget: Government collects more in taxes than it spends → withdraws net money from economy.

Monetary (RBI) Measures:

• Raise CRR and SLR: Banks must keep more as reserves → less money available for lending → credit contracts → AD falls.
• Raise Repo Rate and Bank Rate: Borrowing becomes more expensive → less investment and consumption spending → AD falls.
• Raise Reverse Repo Rate: Banks park more funds with RBI → less money in circulation → AD falls.
• Open Market Operations — Sell Securities: RBI sells government securities → money withdrawn from banks → credit contracts → AD falls.
• Raise Margin Requirements: Less credit available for specific purposes → targeted reduction in AD.

Measures to Correct Deficient Demand (Deflationary Gap)

To reduce deficient demand, the government and RBI need to increase AD by injecting money into the economy:

Fiscal (Government) Measures:

• Increase Government Expenditure: More public spending on infrastructure, welfare → income rises → multiplier effect boosts AD.
• Reduce Taxes: Lower direct taxes → higher disposable income → higher consumption → AD rises.
• Increase Transfer Payments: More subsidies, unemployment benefits → more spending power for households.
• Deficit Budget: Government spends more than it collects → injects net money into economy.

Monetary (RBI) Measures:

• Reduce CRR and SLR: Banks can lend more → credit expands → investment and consumption rise → AD rises.
• Reduce Repo Rate and Bank Rate: Cheaper borrowing → more investment and consumption → AD rises.
• Reduce Reverse Repo Rate: Banks find parking funds with RBI less attractive → lend more to public → AD rises.
• Open Market Operations — Buy Securities: RBI buys government securities → money injected into banks → credit expands → AD rises.
• Reduce Margin Requirements: More credit available → targeted boost to AD.

Key Concepts at a Glance

Sample MCQs — Chapter 9: Excess & Deficient Demand