How Monetary Policy Correct Excess demand situation

After going through Fiscal Policy to control the situation of excess demand, we will know see how monetary policy of the government can be used to solve the situation of increased aggregate demand.

Monetary Policy:

Monetary policy can be used effectively to reduce the excess demand. Monetary policy is the policy of the central bank to achieve various policy of economic policy  which includes components like bank rate, open market operations, cash reserve and statutory liquidity ratio to correct excess demand.Following are the principal components of Monetary policy. Along with each component, we are describing the way it is used to correct situations of excess demand.

Bank rate:

Bank rate is the rate at which the central bank lends money to the commercial banks.

To control the situation of excess demand, bank rate is increased, due to this increase of bank rate by central bank, commercial banks raise the market rate of interest(the rate at which commercial bank lend money to the consumers and investors). This will lead to higher cost of borrowing from commercial banks to the consumers and investors. This reduces demand for credit, thereby leading to less liquidity in the hands of the people.Consumption expenditure and investment expenditure are reduced and aggregate demand (AD) will fall.

How Fiscal Policy Correct Excess demand situation

We have seen that excess demand leads to inflation in the economy, so it’s necessary to correct this excess demand situation.Here, we will see how Fiscal Policy of the government will control the situation of excess demand.

Fiscal Policy:

Fiscal policy can be used effectively to reduce the excess demand. Fiscal policy is the policy of the government which includes components like taxation, public expenditure and public borrowing.

Following are the principal components of fiscal policy. Along with each component, we are describing the way it is used to correct situations of excess demand.

a) Government expenditure:

It is the principal instrument of fiscal policy. The government of a country incurs various types of expenditure, mainly:

i) Expenditure on public work programmes like construction of dams, bridges, roads etc.

ii) Expenditure on education and welfare programmes.

iii) Expenditure on defence and law and order.

iv) Expenditure on subsidies to the producer for encouraging production.

In the situation of excess demand, the government should reduce its expenditure, mainly unproductive expenditure like defence and administrative expenditure, interest payments etc.

Deflationary gap

Deflationary gap is the shortfall in AD from the level required to maintain full employment equilibrium in the economy. In such a situation, there is involuntary unemployment in the economy.

When there is a situation of deficient demand, resources are not fully utilized and there is excess capacity in the economy. The economy moves towards deflation. as the aggregate demand is not sufficient to purchase the potential output, income, output and employment in the economy will fall. Due to excess supply and low demand, prices of commodities fall.

A situation of deflationary pressure emerges in the economy.

Deflationary pressure is proportionate to deficient demand i.e. deflationary gap is a measure of the amount of deficient demand in the economy. 

Greater the deficient demand, greater the deflationary pressure.

Below graph explains the deflationary gap

Deflationary gap

AD : Aggregate demand at full employment

AD₁: Underemployment Aggregate demand

Deficient Demand

Deficient demand refers to the situation when aggregate demand (AD) is in short of aggregate supply (AS) corresponding to fullemployment in the economy.

AD < AS : Corresponding to full employment.

Desired AD in the economy happens to be short of its full employment level. 

It implies that desired AD does not permit production at the full employment, due to deficient demand, equilibrium between desired AD and desired AS is struck at a level lower than full employment in the economy, this is a situation of underemployment equilibrium. 

Deficient demand may be caused by decrease in the value of various components of aggregate demand

i.e.

AD = C + I + G + (X - M)

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

1) Decrease in the consumption expenditure by the household due to increase in the propensity to save and reduction in propensity to consume.

2) Decrease in private investment expenditure.

3) Decrease in government expenditure this may be due to losses in public enterprises. In such a situation, instead of making fresh investment, the government may resort to disinvestment, implying a cut in AD. 

4) Decline in export, owing to lower domestic demand in rest of the world.

5) Rise in imports, owing to lower international prices compared with domestic prices. A rise in import implies a cut in AD as imports are negative components of AD.

6) An increase in tax rates leaving lesser disposable income with the people. This leads to reduction in their capacity to spend

7) Decrease in money supply due to reduction of credit facilities by the commercial banks. 

Below figure illustrates the situation of deficient demand.

deficient demand

AD: Aggregate demand at full employment

AD₁: Aggregate demand corresponding to underemployment

FC: deficient demand

OM: Full employment level of output

ON: equilibrium output owing to underemployment

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

Now, suppose aggregate demand curve shifts downwards to AD₁ due to say, decrease in government expenditure.

At the full employment level of income, the aggregate supply is OM or FM. This is greater than aggregate demand of CM.

The deficient demand at the full employment income is FC 

Deficient demand = FC = AD - AD₁  (FM – CM)

Inflationary gap

Inflationary gap is the excess of Aggregate Demand over and above its level required to maintain full employment equilibrium in the economy.

When there is a situation of excess demand, the level of output does not rise since factors are already fully employed.

Output level remains constant corresponding to full employment. A high level of aggregate spending relative to full employment level of output will generate shortages of goods in the economy, which would push up prices and causes inflation.

A situation of inflationary pressure emerges in the economy.

Inflationary pressure is proportionate to excess demand i.e. inflationary gap is a measure of the amount of excess demand in the economy.

Greater the excess demand, greater the inflationary pressure.

Below graph explains the inflationary gap

Inflationary gap

AD: Aggregate demand at full employment

AD₁: Aggregate demand beyond full employment

AB: Excess demand = inflationary gap

OM: Full employment level of output

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.

Voluntary and Involuntary Unemployment

Voluntary Unemployment 

Voluntary Unemployment occurs when some people are not willing to work at all, are not willing to work at the existing wage rate, these persons are voluntarily unemployed, i.e. unemployed by their choice.

They may not work due to laziness or otherwise, they are not interested in any gainful job. They are unemployed not out of compulsion but due to their choice. We may include both the ‘idle rich’ and ‘idle poor’ in this category. 

Similarly, there may be some anti-social people like thieves and pickpockets who may be voluntarily unemployed.

We do not include such cases of voluntarily unemployed persons under unemployment, therefore these persons are not considered unemployed.   

Involuntary Unemployment 

Involuntary Unemployment refers to the situation when some people are not getting work, even when they are willing to work at the existing wage rate.