Excess Demand

Excess demand refers to the situation when aggregate demand (AD) is in excess and its components of aggregate supply (AS) corresponding to full employment in the economy.

AD > AS : Corresponding to full employment. 

Desired AD in the economy happens to exceed its full employment level.

As it is a situation of full employment, resources are all fully utilized so aggregate supply cannot be raised, increase in demand implies greater pressure on the available goods and services in the economy.

Accordingly, price of existing goods and services tends to rise.

Excess demand may be caused by increase in the value of various components of aggregate demand.

i.e.

AD = C + I + G + (X - M) 

Thus, excess demand may be caused by the following factors: 

1) Increase in the consumption expenditure by the household due to increase in the propensity to consume.

2) Increase in private investment expenditure.

3) Increase in government expenditure, owing to its active participation in the process of growth and social welfare.

4) Increase in export, owing to lower domestic prices in relation to international prices.

5) Decrease in imports, owing to higher international prices compared with domestic prices.

6) A cut in tax rates leaving higher disposable income with the people.

7) Increase in money supply due to expansion of credit facilities by the commercial banks.

Below figure illustrates the situation of excess demand.

excess demand

AD : Aggregate demand at full employment

AD₁: Aggregate demand beyond full employment

AB: Excess demand

OM: Full employment level of output

AD is Full employment Aggregate Demand. The intersection of AD  curve with 45^◦ line at B gives us the equilibrium corresponding to full employment level of output M.

Now, suppose aggregate demand curve shifts upwards to AD₁ due to say, increase in government expenditure.

The output will not rise since the economy is at full employment level of output and there will emerge excess demand in the economy. 

Excess demand = AB = AD₁ - AD 

The difference between the aggregate demand and the aggregate output at full employment is known as excess demand.