How Monetary Policy Correct deficient demand situation

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

Monetary Policy:

Monetary policy can be used effectively to control the situation of deficient 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 deficient 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 deficient demand.

How Fiscal Policy Correct deficient demand situation

We have seen that deficient demand leads to deflation in the economy, 

so it’s  necessary to correct this deficient demand situation. Here, we will see how Fiscal Policy of the government will control the situation of deficient demand.

Fiscal Policy: 

Fiscal policy can be used effectively to raise demand in the economy to correct the situation of deficient 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 deficient 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 deficient demand, the government should increase its expenditure (as said above).

Increasing government expenditure means increasing government spending. We have read in investment multiplier mechanism that expenditure leads income generation.

Expenditure by one person becomes the income of another person.

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