AGGREGATE DEMAND

Aggregate Demand & Related concepts

AGGREGATE DEMAND

Definition: Aggregate demand refers to the total demand for final goods and services in an economy during an accounting year.

Aggregate demand is aggregate expenditure on ex-ante (planned) consumption and ex-ante (planned) investment that all sectors of the economy are willing to incur at each income level.

Components of Aggregate Demand:

Private (or Household) consumption demand

The total expenditure incurred by all the households of the country on their personal consumption is known as private consumption expenditure.

Consumption demand depends mainly on disposable income and propensity to consume.

Private investment demand

Private investment demand refers to the demand for capital goods by private investors.

It is addition to the existing stock of real capital assets such as machines, tools, factory – building etc.

Investments demand depends upon marginal efficiency of capital (Marginal efficiency of investment) and interest rate.

Investment is of two types, Autonomous Investment and Induced investment, but in Keynes theory investment is assumed to be Autonomous.

The basic difference between Induced Investment and Autonomous Investment

Government Expenditure

Government demand for goods and services. Its curve is upward sloping rises up to Right.

In a modern economy, the government is an important buyer of goods and services.

It is income inelastic, i.e., it is not affected by change in income level. The volume of autonomous investment is the same at all levels of income.
Its curve is a straight line parallel to horizontal axis.

The government demand may be because of public needs for roads, schools, hospitals, power, etc, for the maintenance of law and order and for defence.

Demand for net export (X – M)

Net export represents foreign demand for goods and services produced by an economy.

When exports exceed imports, net exports is positive and when imports exceed, net exports is negative.

Exports and imports of a country are influenced by a number of factors such as foreign trade policy, exchange- rate, prices and quality of goods etc.
Thus, aggregate demand consists of these four types of demand.

http://macrotutor.weebly.com/uploads/2/9/3/4/2934776/4478920.png?352x130

However, for the sake of simplicity Keynes included only two types of demand,
-> Consumption demand (C)
-> Investment demand (I)

Diagrammatic representation of AD

https://1.bp.blogspot.com/-tD4La3y8wmA/XjUoXVvx-sI/AAAAAAAAB8c/68iCBE7zV14R8srRdhDz53MQbIMneoQdwCLcBGAsYHQ/s320/Capture.PNG

AGGREGATE DEMAND SCHEDULE

AGGREGATE SUPPLY

AGGREGATE SUPPLY

Definition: Aggregate supply refers to money value of final goods and services that all the producers are willing to supply in an economy in a given period.

The concept of aggregate supply (ΔS) is related with the total supply of goods and services by all the producers in an economy. Four factor of production like land, labour, capital and enterprise are required for the production of goods and services. Producers pay rent to land, wages and salaries to labour, interest to capital and Profits to the entrepreneur for their services in production. This payment is factor- cost from producer’s point of view and factor-income from factor-owner angle.

Thus, aggregate supply is the total amount of money value of goods and services, (which is paid to the factor of production against their factor services) that all the producers are willing to supply in an economy. In other words, it is the total cost of production of goods and services produced in a country or it is the value of net national product at factor cost (NNPFC). We can say Aggregate Supply (AS) = National Income (Y)

Keynes assumed his economy to be a closed capitalist economy and whenever any economy is closed capitalist, then Net Factor Income from Abroad (NFIA) is zero. National Income (NNPFC) = Domestic Income (NDPFC) + Net Factor Income from Abroad (NFIA)
National Income (NNPFC) = Domestic Income (NDPFC) + 0
In short,
Aggregate Supply = NNPFC = NDPFC = Factor Income = Rent + Interest + Wages + Profit

As we know income is either consumed or saved, hence for the sake of simplicity Keynes has regarded only two main constituents of aggregate supply:

NATIONAL INCOME (Y) = CONSUMPTION + SAVING

Y = AGGREGATE SUPPLY = CONSUMPTION + SAVING

Aggregate Supply Schedule and Diagrammatic Representation:

https://tse3.mm.bing.net/th?id=OIP.lXBbDE32aPuXfGdEghmqBAHaDA&pid=Api&P=0&w=404&h=164

In the above figure, income is represented on the X-axis and consumption and saving are measured on the Y-axis. A 45-degree line, which represents the Aggregate Supply, has been drawn from the origin. At every point on this 45 degree line, Y = C + S.

 

CONSUMPTION FUNCTION

CONSUMPTION FUNCTION

Definition: Consumption function refers to that portion of income, which is spent on the purchase of goods and services at the given level of income.

Consumption function expresses functional relationship between aggregate consumption and national income.
Thus, consumption (C) is a function of income (Y). C = f(Y)
Where, C = Consumption; f = Functional relationship; Y = Disposable income Consumption at a point of time can be measured with the equation:

According to Keynes, as income increases consumption expenditure also increases but increase in consumption is smaller than the increase in income. In other words, consumption lags behind income. This is called Keynes’ Psychological law of Consumption. According to Keynes, propensity to consume of the people remains stable in the short period.

Break-even point refers to that point in the level of income at which consumption is just equal to income. In other words, whole of income is spent on consumption and there is no saving. Below this level of income, consumption is greater than income but above this level, income is greater than consumption.

Consumption Schedule

Consumption Curve

https://1.bp.blogspot.com/-63GMAPLjq7I/XjUsX1vvbPI/AAAAAAAAB8o/h7xXVtkKESgVKiH_ujRlO40BY8DPI30VwCLcBGAsYHQ/s320/Capture.PNG

In the given imaginary household schedule of consumption, at annual income level of Rs.200 Crore, consumption is Rs.200 Crore and in consequence, there is no
saving. This is break-even point.

It is evident from the table and diagram that:

As the income increases, consumption also increases, but the increase in consumption remains less than the increase in income.

Income can be zero but consumption can never be zero in the economy.

When C > Y, saving are negative.

When C = Y, savings are zero. This is known as break-even point. This is shown by intersection of blue and red line in the diagram.

Thus, break-even point indicates a point where consumption becomes equal to income or consumption curve cuts the income curve.

TYPES OF PROPENSITIES TO CONSUME

TYPES OF PROPENSITIES TO CONSUME

Average Propensity of Consume

Marginal Propensity to Consume

Average propensity to consume (APC):

Definition: The ratio of aggregate consumption expenditure to aggregate income is known, as average propensity to consume.

It indicates the percentage (or ratio) of income which is being spent on consumption.

APC = Consumption (C) / Income (Y)

It can be explained with the help of following schedule and diagram:

https://tse4.mm.bing.net/th?id=OIP.5P7N3Bj1dT4TXq1V1Wt4MAHaCa&pid=Api&P=0&w=435&h=142

Important Points for APC:

When APC is more than 1: When APC is more than 1, consumption is more than national income, i.e. before the break-even point.
APC = 1: When APC is equal to 1, consumption is equal to national income, which is known as to be break-even point.
When APC is less than 1: When consumption is less than national income, i.e. beyond the break-even point.

Marginal Propensity to consume (MPC):

Definition: The ratio of change in consumption (C) to change in income (Y) is known as marginal propensity to consume.

It indicates the proportion of additional income that is being spent on consumption.

MPC = Change in Consumption / Change in Income

It can be explained with the help of following schedule and diagram:

https://www.learninsta.com/wp-content/uploads/2021/01/Economics-Class-12-Important-Questions-Chapter-4-Determination-of-Income-and-Employment-12.png

Important points for MPC:

Value of MPC varies between 0 and 1: As we know that increase in income is either spent on consumption or saved for future use.
MPC falls with the successive increase in income: It happens because as an economy becomes richer, it has the tendency to consume smaller percentage of each increment to its income.

DIFFERENCE BETWEEN APC & MPC

SAVING FUNCTION & NUMERICALS

SAVING FUNCTION (PROPENSITY TO SAVE)

Definition: Saving function refers to a functional relationship between saving and national income.

S= f(Y)

Where, S = Saving, Y = National Income, f = Functional relationship

Saving Schedule and Curve:

Saving curve (SS) starts from a below point on the Y-axis, indicating that there is negative saving (equal to amount of autonomous consumption) when national income is zero.

Note: The saving curve will have a negative intercept on Y-axis of the same magnitude as the consumption curve has positive intercept on the Y-axis. It happens because if consumption were positive at zero level of income, then there would be dis-savings of the same magnitude.

Break-even point (S = 0). Saving curve crosses the X-axis at point R which is known as break-even point as at this point saving is zero (or consumption is equal to income).

Positive Saving: After the break-even point, saving is positive.

TYPES OF PROPENSITIES TO SAVE

TYPES OF PROPENSITIES TO SAVE

Average Propensity to Save (APS)

Marginal Propensity to Save (MPS)

Average propensity to save (APS) :
Definition: The ratio of aggregate saving to aggregate income is known as average propensity to save (APS).

By dividing aggregate saving by aggregate income, we get APS.

APS = Saving (S) / Income (Y)

APS Schedule & Curve:

Important Points for APS:

APS can never be 1 or more than one. As saving, can never be equal to or more than national income.

APS can be 0: APS is 0 when income is equal to consumption i.e., saving = 0. This point is known as break-even point.

APS can be negative or less than 1. At income levels which are lower than the break-even point APS can be negative as there will be dis-savings in the economy.

APS rises with increase in income. APS rises with the increase in income because the proportion of income saved keeps on increasing.

Marginal Propensity to Save:

Definition: The ratio of change in saving (ΔS) to change in income (ΔY) is called MPS.

 It is proportion of income saved out of additional (incremental) income.

MPC = Change in Saving / Change in Income

MPC Schedule & Curve:

 

Important points for MPS:

Since MPS measures the slope of saving curve, constant value of MPS means that the saving curve is a straight line.

MPS varies between 0 and 1.If the entire additional income is saved then MPS = 1.

However, if the entire additional income is consumed, MPS = 0.

Comparison between APS & MPS.

Relationship between APC & APS

Y = C+S

Dividing both sided by Y,

Y/Y = C/Y + S/Y

: 1 = APC + APS

Relationship between MPC & MPS

Change in Y = Change in C + Change in S

Dividing both side by Change in Y,

Change in Y/Change in Y = Change in C/Change in Y + Change is S/Change in Y

: 1 = MPC + MPS

DERIVATION OF SAVINGS CURVE FROM CONSUMPTION CURVE

EQUATION OF CONSUMPTION CURVE

Consumption curve can be put into two parts:

When income is zero, there is some consumption, which is known as autonomous consumption.

When income increases, consumption also increases but the rate of increase in income is more than that of increasing consumption and this rate depends upon MPC. The consumption pictures influenced by income is known as induced consumption, which can be estimated by multiplying MPC by income. i.e. b(Y)

Therefore, consumption can be represented as:

C= C̅+b(Y)

Where

C̅=Autonomous consumption

C= consumption, 

b= MPC

Y= Income

EQUATION OF SAVING FUNCTION

With the help of linear consumption function situations, we can derive the equation of the linear saving function.

We know, Y=S+C

                 S=Y-C………………(1)

And         C=C̅+b(Y)………….(2)

Putting the value of C in equation 1 we get.

S=Y-(C̅+b(Y))

S=Y-C̅-b(Y)

S= -C̅+Y-b(Y)

S=-C̅+Y(1-b)

Where,

S=savings

C̅=amount of dissaving’s at 0 levels of income.

Y= total income

1 – b = 1 – MPC = MPS

Derivation of Saving Curve from Consumption Curve

Let us understand how we derive the saving curve from the consumption curve:

At zero level of income, autonomous consumption is OC, which means that savings will be OS and hence saving curve will start from the point as on the negative y-axis.

Consumption curve intersects income curve at. Which means it is break-even point where consumption is equal to income, and savings are zero. Therefore, at this particular point saving curve will intersect the x-axis at point r. By joining points S and R and extending it further, we get the saving curve SS.

DERIVATION OF CONSUMPTION CURVE FROM SAVINGS CURVE

DERIVATION OF CONSUMPTION CURVE FROM SAVING CURVE

 

INVESTMENT FUNCTION

INVESTMENT FUNCTION

Definition: Investment refers to the expenditure incurred on the creation of New Capital Asset. For example, expenditure incurred on the purchase of machinery, building, equipment, etc.

It can be of two types:

(1) Induced investment

(2) Autonomous investment

Induced Investment

Definition: Induced investment is that investment, which is directly influenced by the level of income that is it, increases with income and it falls with a fall in income. These are made for profit Motive.

Autonomous Investment

Definition: Autonomous investment refers to investment, which is not influenced by the level of income. These are not made for-profit motive.

The government on infrastructure activities generally makes these types of investments.

The level of autonomous investment depends upon social, economic and political conditions of any country hence its take it changes when there is a change in technology on the discovery of new resources or growth of population, etc.

Difference between Induced Investment & Autonomous Investment.

https://www.rbseguide.com/wp-content/uploads/2019/07/RBSE-Solutions-for-Class-12-Economics-Chapter-20-Concept-of-Consumption-Functions-Savings-Function-and-Investment-Function-4.png

DETERMINANTS OF INVESTMENT

Investment in a new project depends upon two factors:

Marginal efficiency of investment

Rate of interest.

Marginal Efficiency of Investment:

Definition: Marginal efficiency of investment refers to the expected rate of return from additional investment.

It is determined by two factors:

Supply price: it happens to the cost of producing a new asset of that kind. It is the price at which the new capital can be supplied or replaced. for example, if a machine of rupees 1100000 is replaced in place of an old machine, then Rupees 1 lakh is supplied price

Protective yield: it refers to net return expected from the Capital Asset over its lifetime. For example, if the expected yield from a machine is rupees 8000 and running expenses are rupees 500 then protective Shield could be rupees 8000 - 500 is equal to Rs 7500.

In the above example, MEI will be calculated as follows:

MEI = Protective yield / Supply price * 100

MEI = 7500/100000 = 7.5%

Rate of Interest:

It refers to the cost of borrowing money for financing Investments. There exist an inverse relationship between ROI and volume of investment. At a higher ROI, investment soending will be less and vice-versa.

COMAPARISON OF MEI & ROI:

Profitability of an investment can be worked out by comparing MEI with ROI. IF MEI >ROI, investment is profitable as at this point, return from investment is more as compared to cost and if MEI<ROI, investment is not profitable as at this point return from investment is less as compared to cost.

SAVINGS & INVESTMENT

INVESTMENT

Investment or capital formation refers to addition to the capital stock of an economy. For example-Construction of roads, flyovers, Building, etc.

Investment can be of two forms:

  • Gross Investment
    • Definition: It is an addition to the stock of capital before making allowance for depreciation
  • Net Investment
    • Definition: Net Investment is an actual addition made to the capital stock of the economy in a given period.

Net Investment = Gross Investment- Depreciation

EX-ANTE & EX-POST SAVING AND INVESTMENT

Definition: Ex-ante means planned or expected value of the variable, whereas Ex-post means an actual or realized value of the variable.

Both are generally used in the context of saving and investment. There are two aspects of Savings and Investments:

  • Ex Ante saving and Ex Ante investments
  • Ex-post saving and Ex post investments

Ex-Ante Savings

Refers to the amount, which households are planning to save at different level of income in the economy.

Ex-Ante Investments

It refers to the amount of investment, which firms plan to invest at a different level of income in the economy.

EX-POST SAVINGS

Ex-post saving refers to actually organized saving in an economy during the year.

EX-POST INVESTMENTS

It refers to actual or realized investment in an economy during a year.

 

FULL EMPLOYMENT

FULL EMPLOYMENT

Definition: Full employment refers to a situation in which all those people who are willing and able to work at the existing wage rate get work without any due difficulty. Ordinarily, the term full employment refers to the situation in which no one is employed.

Under full employment, there can be two types of unemployment:

Frictional unemployment: Sometimes people leave one job in search for some other job and remain vacant between these periods; this is termed as frictional unemployment.

Structural unemployment: Where people remain unemployed due to a mismatch between unemployed person and demand for a specific type of workers. For example, due to the introduction of new technology, the old staff become unemployed as now they do not possess enough exercise to do a particular job.

UNEMPLOYMENT

INVOLUNTARY UNEMPLOYMENT

Definition: It refers to an unemployment in which all those people, who are willing and able to work at the existing wage rate, do not get work.

It must be noted that only involuntary unemployment is considered while estimating the total unemployment in an economy.

VOLUNTARY UNEMPLOYMENT

Voluntary unemployment refers to a situation when a person is unemployed because he/she is not willing to work at the existing wage rate.

Voluntary unemployment is not counted while estimating the size of unemployment.

EQUILIBRIUM LEVEL

EQUILIBRIUM LEVEL

According to Keynes Theory, an economy is in equilibrium when aggregate demand of goods and services is equal to aggregate supply during a period of time.

Equilibrium is achieved when,

AD=AS (1)

Since,

AD= C + I   

AS = C + S

: C + I = C + S

  Or S = I

The two approaches for equilibrium are-

1. AD-AS approach.

2. S-I approach

Before proceeding, we will make the following assumption for better understanding:-

Only two-sector exists in an economy (households and firms). There is no government & foreign sector.

It is assumed that Investment is autonomous i.e. it is not influenced by the level of income.

Price level is assumed to be constant.

Equilibrium output is to be determined in the context of short-run.

AGGREGATE DEMAND AND AGGREGATE SUPPLY APPROACH (AD-AS Approach)

According to Keynesian Theory, the equilibrium level of income in an economy is determined when aggregate demand, represented by C+I curve is equal to the total output (Aggregate Supply or AS).

Aggregate Demand Comprises of Two components:-

Consumption Expenditure (C):- It varies directly with the level of income i.e. consumption rises with the increase in income.

Investment Expenditure (I):- It is assumed to be independent of the level of income i.e. investment expenditure is autonomous.

Aggregate Supply is the total output of goods and services of the national income, since income is either consumed or saved, the AS curve is represented by the (C+S) curve.

Equilibrium by AD and AS approach

Observation from the above Schedule and Diagram

Investment Curve -(I) is parallel to X-axis as it is autonomous and does not depends upon the level of income whereas saving curve(S) is upward sloping as saving increase with rising in Income. The Economy would be in equilibrium at point E where saving and investment intersect each other. At this level planned savings are equal to planned investments.

When savings are more than Investments -If planned savings are more than planned investment, i.e. after point E, a household is not consuming as much as firms expected them to as a result, the inventory would rise above the desired level.

When savings are less than investments- If planned savings are less than Investments, i.e. before point E, a household is consuming more, and savings less than what firms expected them to as a result planned inventory would fall below the desired level.

The economy is in equilibrium at point E where AD=AS.

E is the equilibrium point because, at this point, the level of the desired spending on consumption and investment exactly equals the level of total output.

OY is the equilibrium level of output corresponding to point E.

The equilibrium level of income is rupees 400 crores, where AD=AS

It is a situation of effective demand. Effective demand refers to that level of AD, which become effective because it is equal to AS.

When AD is more than AS

When planned spending is more than planned output (AS) it means that people are ready to spend more and firms are willing to produce less as a result planned inventory would fall below the desired level.

When AD is less than AS

When planned to spend a less than planned output it means that people are not ready to spend more and firms are willing to produce more as a result planned inventory would rise above the desired level.

SAVING – INVESTMENT APPROACH (S-I Approach)

According to S-I approach equilibrium level is determined at a point where planned savings are equal to planned Investments.

Schedule & Diagram:

https://i.pinimg.com/originals/6b/98/9e/6b989e366a39c7adc443d2085ed377ac.png

Investment Curve is parallel to the x-axis as it is autonomous and does not depends upon the level of income. Whereas the saving curve is upward sloping as savings increases with rising in income .the economy would. Be in equilibrium at point E where saving and investment intersect each other. At this level, planned savings are equal to planned investment.

When savings are more than investment

If planned savings are more than planned investment that is after. Point E houses are not consuming as much as firms expected them to. As a result, the inventory would rise above the desired level.

When savings are less than Investments.

If plant savings are less than investment before Point E households are consuming more and saving less than what firms expected them to. As a result, planned inventory would fall below the desired level.

Equilibrium Level

According to the classical economics equilibrium level of income is attained always at full employment level i.e. there is the absence of involuntary unemployment. However, as per the Keynesian Theory of Equilibrium level can be achieved at-

1. Full Employment Level or

2. Under Employment Level i.e. less than full employment level or

3. Over Employment Level i.e. more than full employment level.

Full Employment Equilibrium

It refers to a situation when equality between AD and AS takes place at the full employment level of income.

In the given figure, Full Employment equilibrium is achieved at Point ‘E’ where EM is equal to OM. At this particular point, there is no involuntary unemployment i.e. those who are willing and able to work are getting it at a prevailing wage rate.

Under Employment Equilibrium

It refers to a situation when aggregate demand is equal to aggregate supply beyond the full employment level.

https://www.zigya.com/application/zrc/images/qvar/ECEN12051387.png

Here, AD = AS at Point E1 which is lower than full employment level. As OM1 is less than OM, Point ‘E1’ signifies the underemployment equilibrium.

Over full Employment Equilibrium

It refers to a situation when the equilibrium between AD & AS takes place at more than full Employment Level.

Here, AD, = AS at point E1 which is higher than the full employment level. Point E1 signifies the over full-employment equilibrium.

INVESTMENT MULTIPLIER

INVESTMENT MULTIPLIER

Keynes believed that an initial increment in investment increases the final income by many times. Multiplier (K) is the ratio of increase in national income (Y) due to an increase in investment (I).

Symbolically, K = Y / I

Multiplier and MPC

There exist a direct relationship between MPC and the value of the multiplier, higher the MPC, more will be the value of the multiplier, and vice-versa. The reason for this is:

In the case of higher MPC, people will spend a large proportion of their income on consumption. In such case, the value of multiplier will be more.

In case of low MPC, people will spend lesser proportion of their increased income on consumption. In such case, value of multiplier will be comparatively less.

Algebraically, since, Y = C + I

Therefore change in Y = change in C + change in I

Dividing both sides by Y

Y/Y = C/Y + I/Y

1 = MPC + I/K (: Y/Y = 1, C/Y = MPC, I/Y = I/K)

1 – MPC = I/K

K= I /1-MPC or I / PC (: I - MC = MPS)

Multiplier is directly related to MPC and inversely related to MPS

The above statement can be easily proved through the following table:-

It is clearly seen in the above table that as MPC is increasing, Multiplier is also increasing which shows positive relationship whereas it is increase with fall in MPS, which shows negative relationship.

The maximum value of the multiplier can be infinity when MPC is I and MPS is Zero whereas the minimum value of the multiplier can be I when MPC is 0 and MPS is 1.

Working of Multiplier

The working of multiplier is based on fact that ‘One person’s expenditure is another person’s income’. When an additional investment is made, then income increased many times more than the increase in investment. Let us understand this with the help of an example:-

  1. Suppose the government for some infrastructural activities makes an additional investment of Rs.1000 crores. This will generate an extra income of Rs.1000 crores in the first round. However, this is not the end of the story.
  2. If MPC is assumed to be 0.80, then the recipient of this additional income will spend 80% of Rs.1000 crore i.e. Rs 8000 crore as consumption and remaining amount will be saved. It will increase the income by Rs. 800 Crore in second round.
  3. In next round, 90% of additional income of Rs.8000 crore i.e. Rs. 640 crore will be spent on consumption and the remaining amount will be saved.
  4. This multiplier process will go on and consumption in every round will be 0.80 times of additional income received from the previous round.
  5. Here value of Multiplier(K) =Y/I = 5000/1000=5 times Or I/MPS (I/I-MPC) =1/0.20 = 5 times
  6. Therefore, an initial increase in investment by one unit will increase total national income by 5 times.

Diagrammatic presentation of Multiplier:

https://www.learncbse.in/wp-content/uploads/2019/09/NCERT-Solutions-for-Class-12-Macro-Economics-National-Income-Determination-and-Multiplier-Q3.png

EXCESS DEMAND

Excess Demand

Definition: Excess Demand refers to a situation when aggregate demand is more than the aggregate supply corresponding to full employment level of output in the economy.

excess-demand-deficient-demand-cbse-notes-class-12-macro-economics-1

Inflationary gap is the gap showing excess of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called inflationary because it leads to inflation (continuous rise in prices).

Here is a simple example, let us suppose that an imaginary economy by employing all its available resources can produce 10,000 quintals of rice. If aggregate demand of rice is say 12,000 quintals, this demand will be called an excess demand, because aggregate supply at level of full employment of resources is only 10,000 quintals and the result of the gap of 2000 quintals will be called as inflationary gap. In the above diagram Inflationary gap is AB because at Full employment (Y*), Aggregate demand (BY*) is greater than Aggregate Supply (AY*).

Reasons for Excess Demand:

Increase in household consumption demand due to rise in propensity to consume.

Increase in private investment demand because of rise in credit facilities.

Increase in public (government) expenditure.

Increase in export demand.

Increase in money supply or increase in disposable income.

Impacts of Excess Demand on Price, Output & Employment:

Effect on General Price Level: Excess demand gives a rise to general price level because it arises when aggregate demand is more than aggregate supply at a full employment level. There is inflation in economy showing inflationary gap.

Effect on Output: Excess demand has no effect on the level of output. Economy is at full employment level and there is no idle capacity in the economy. Hence, output cannot increase.

Effect on Employment: There will be no change in the level of employment also.
The economy is already operating at full employment equilibrium, and hence, there is no unemployment.

Deficient Demand:

Definition: When in an economy, aggregate demand falls short of aggregate supply at full employment level, the demand is said to be a deficient demand.

excess-demand-deficient-demand-cbse-notes-class-12-macro-economics-2

Deflationary gap is the gap showing Demand deficient of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called deflationary because it leads to deflation (continuous fall in prices).

Let us suppose that an imaginary economy by employing all its available resources can produce 10,000 quintals of rice. If aggregate demand of rice is, say 8,000 quintals, this demand will be called a deficient demand and the gap of 2000 quintals will be called as deflationary gap. Clearly here, equilibrium between AD and AS is at a point less than level of full employment. Keynes called it an under employment equilibrium.

Reasons for Deficient Demand:

Decrease in household consumption demand due to fall in propensity to consume.

Decrease in private investment demand because of fall in credit facilities.

Decrease in public (government) expenditure.

Decrease in export demand.

Decrease in money supply or decrease in disposable income.

Impacts or effects of deficient demand:

Effect on General Price Level: Deficient demand causes the general price level to fall because it arises when aggregate demand is less than aggregate supply at full employment level. There is deflation in an economy showing deflationary gap.

Effect on Employment: Due to deficient demand, investment level is reduced, which causes involuntary unemployment in the economy due to fall in the planned output.

Effect on Output: Low level of investment and employment implies low level of output.

DIFFERENCE BETWEEN EXCESS DEMAND & DEFICIENT DEMAND:

 

DEFICIENT DEMAND

Deficient Demand:

Definition: When in an economy, aggregate demand falls short of aggregate supply at full employment level, the demand is said to be a deficient demand.

  • Deflationary gap is the gap showing Demand deficient of current aggregate demand over ‘aggregate supply at the level of full employment’. It is called deflationary because it leads to deflation (continuous fall in prices).
  • Let us suppose that an imaginary economy by employing all its available resources can produce 10,000 quintals of rice. If aggregate demand of rice is, say 8,000 quintals, this demand will be called a deficient demand and the gap of 2000 quintals will be called as deflationary gap. Clearly here, equilibrium between AD and AS is at a point less than level of full employment. Keynes called it an under employment equilibrium.

Reasons for Deficient Demand:

  • Decrease in household consumption demand due to fall in propensity to consume.
  • Decrease in private investment demand because of fall in credit facilities.
  • Decrease in public (government) expenditure.
  • Decrease in export demand.
  • Decrease in money supply or decrease in disposable income.

Impacts or effects of deficient demand:

  • Effect on General Price Level: Deficient demand causes the general price level to fall because it arises when aggregate demand is less than aggregate supply at full employment level. There is deflation in an economy showing deflationary gap.
  • Effect on Employment: Due to deficient demand, investment level is reduced, which causes involuntary unemployment in the economy due to fall in the planned output.
  • Effect on Output: Low level of investment and employment implies low level of output.

DIFFERENCE BETWEEN EXCESS DEMAND & DEFICIENT DEMAND:

 

MEASURES TO CONTROL AD - MONETARY POLICY & FISCAL POLICY

MEASURES TO CONTROL EXCESS DEMAND

We can control the excess demand with the help of the following policy:

(1) Monetary Policy

(2) Fiscal Policy

(a) Monetary Policy: Monetary policy is the policy of the central bank of a county to control money supply and availability of credit in the economy. The central bank can take the following steps:

1. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:

Bank Rate or Discount Rate (Increase in Bank Rate)

Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to public.

In a situation of excess demand leading to inflation.

Central bank raises bank rate that discourages commercial banks in borrowing from central bank, as it will increase the cost of borrowing of commercial bank.

It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.

Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.

Thus, expenditure on investment and consumption is reduced, which will control the excess demand.

Repo Rate (Increase in Repo Rate):

Repo rate is the rate at which commercial banks borrow money from the central bank for short period by selling their financial securities to the central bank.

These securities are pledged as a security for the loans.

It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.

Therefore, keeping securities and borrowing is repo rate.

In a situation of excess demand leading to inflation, Central bank raises repo rate that discourages commercial banks in borrowing from central bank, as it will increase the cost of borrowing of commercial bank.

It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which discourages investment.

Again high rate of interest induces households to increase their savings by restricting expenditure on consumption.

Thus, expenditure on investment and consumption is reduced, which will control the excess demand.

Reverse Repo Rate (Increase in Reverse Repo Rate):

It is the rate at which the central bank (RBI) borrows money from commercial bank.

In a situation of excess demand leading to inflation, Reverse repo rate is increased, it encourages the commercial bank to park their funds with the central bank to earn higher return on idle cash. It decreases the lending capability of commercial banks, which controls excess demand.

Open Market Operations (OMO) (Sale of securities):

It consists of buying and selling of government securities and bonds in the open market by central bank.

In a situation of excess demand leading to inflation, central bank sells government securities and bonds to commercial bank. With the sale of these securities, the power of commercial bank of giving loans decreases, which will control excess demand.

Increase in Varying Reserve Requirements or Legal Reserve Ratio:

Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.

Cash Reserve Ratio (Increase in CRR):

It refers to the minimum percentage of a bank’s total deposits, which
it is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.

For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs.100 crore, it will have to keep Rs.10 crore with the central bank.

In a situation of excess demand leading to inflation, cash reserve ratio (CRR) is raised to 20 percent. The bank will have to keep Rs.20 crore with the central bank, which will reduce the cash resources of commercial bank and reducing credit availability in the economy, which will control excess demand.

Statutory Liquidity Ratio (Increase SLR):

It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.

In a situation of excess demand leading to inflation, the central bank increases statutory liquidity ratio (SLR), which will reduce the cash resources of commercial bank and reducing credit availability in the economy.

2. Qualitative Instruments or Selective Tools of Monetary Policy: 

These instruments are used to regulate the direction of credit. They are as under:

Imposing margin requirement on secured loans (Increase):

Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.

Therefore, the difference between the value of security and value of loan is called marginal requirement.

In a situation of excess demand leading to inflation, central bank raises marginal requirements. This discourages borrowing because it makes people get less credit against their securities.

Moral Suasion:

Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.

In a situation of excess demand leading to inflation, it appeals for credit contraction.

Selective Credit Control (SCC) [Introduce Credit Rationing]:

In this method, the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.

In a situation of excess demand leading to inflation, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.

(b) Fiscal Policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy. A general government can take the following steps:

Revenue Policy (Increase Taxes):

Revenue policy is expressed in terms of taxes.

During inflation the government impose higher amount of taxes causing the decrease in purchasing power of the people.

It is so because to control excess demand we have to reduce the amount of liquidity from the economy.

Expenditure Policy (Reduces Expenditure):

Government has to invest huge amount on public works like roads, buildings, irrigation works, etc.

During inflation, government should curtail (reduce) its expenditure on public works like roads, buildings, irrigation works thereby reducing the money income of the people and their demand for goods and services.

Increase in Public Borrowing/Public Debt:

This measure means that government should raise loans from public and hence borrowing decreases the purchasing power of people by leaving them with lesser amount of money.

Therefore, government should resort to more public borrowing during excessive demand.

Government should make long term debts more attractive so that public may use their excess liquidity amount of money in purchasing these bonds, which will reduce the liquidity amount of money in the economy and thereby inflation could be controlled

Measures to Control the deficient demand:

We can control the deficient demand with the help of the following policies:

(a) Monetary policy

(b) Fiscal policy

Monetary Policy: Monetary policy is the policy of the central bank of a country of controlling money supply and availability of credit in the economy. The central bank takes the following steps:

1. Quantitative Instruments or General Tools of Monetary Policy: These are the instruments of monetary policy that affect overall supply of money/credit in the economy. These instruments do not direct or restrict the flow of credit to some specific sectors of the economy. They are as under:

Bank Rate or Discount Rate (Decrease in Bank Rate):

Bank rate is the rate of interest at which central bank lends to commercial banks without any collateral (security for purpose of loan). The thing, which has to be remembered, is that central bank lends to commercial banks and not to public.

In a situation of deficient demand leading to deflation, Central bank decreases bank rate that encourages commercial banks in borrowing from central bank as it will decrease the cost of borrowing of commercial bank.

Decrease in bank rate makes commercial bank to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.

Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.

Thus, expenditure on investment and consumption increase, which will control the deficient demand.

Repo Rate (Decrease Repo Rate):

Repo rate is the rate at which commercial banks borrow money from the central bank for short period by selling their financial securities to the central bank.

These securities are pledged as a security for the loans.

It is called Repurchase rate as this involves commercial bank selling securities to RBI to borrow the money with an agreement to repurchase them at a later date and at a predetermined price.

Therefore, keeping securities and borrowing is repo rate.
In a situation of deficient demand leading to deflation, Central bank decreases Repo rate that encourages commercial banks in borrowing from central bank, as it will decrease the cost of borrowing of commercial bank.

Decrease in Repo rate makes commercial banks to decrease their lending rates, which encourages borrowers from taking loans, which encourages investment.

Again low rate of interest induces households to decrease their savings by increasing expenditure on consumption.

Thus, expenditure on investment and consumption increase, which will control the deficient demand.

Reverse Repo Rate (Decrease Reverse Repo Rate):

It is the rate at which the central bank (RBI) borrows money from commercial bank.

In a situation of deficient demand leading to deflation, Reverse repo rate is decreased, it discourages the commercial bank to park their funds with the central bank. It increases the lending capability of commercial banks, which controls deficient demand.

Open Market Operation (Purchase of Securities):

It consists of buying and selling of government securities and bonds in the open market by central bank.

In a situation of deficient demand leading to deflation, central bank purchases government securities and bonds from commercial bank. With the purchase of these securities, the power of commercial bank of giving loans increases, which will control deficient demand.

Decrease in Varying Reserve Requirements: 

Banks are obliged to maintain reserves with the central bank, which is known as legal reserve ratio. It has two components. One is the Cash Reserve Ratio or CRR and the other is the SLR or Statutory Liquidity Ratio.

Cash Reserve Ratio (Decrease):

It refers to the minimum percentage of a bank’s total deposits, which is required to keep with the central bank. Commercial banks have to keep with the central bank a certain percentage of their deposits in the form of cash reserves as a matter of law.

For example, if the minimum reserve ratio is 10% and total deposits of a certain bank is Rs. 100 crore, it will have to keep Rs.10 crore with the central bank.

In a situation of deficient demand leading to deflation, cash reserve ratio (CRR) falls to 5 percent, the bank will have to keep Rs. 5 crore with the central bank, which will increase the cash resources of commercial bank and increasing credit availability in the economy, which will control deficient demand.

The Statutory Liquidity Ratio (SLR) (Increase):

It refers to minimum percentage of net total demand and time liabilities, which commercial banks are required to maintain with themselves.

In a situation of deficient demand leading to deflation, the central bank decreases statutory liquidity ratio (SLR), which will increase the cash resources of commercial bank and increases credit availability in the economy.

2. Qualitative Instruments or Selective Tools of Monetary Policy: These
instruments are used to regulate the direction of credit. They are as under:

Imposing margin requirement on secured loans (Decrease):

Business and traders get credit from commercial bank against the security of their goods. Bank never gives credit equal to the full value of the security. It always pays less value than the security.

Therefore, the difference between the value of security and value of loan is called marginal requirement.

In a situation of deficient demand leading to deflation, central bank decreases marginal requirements. This encourages borrowing because it makes people get more credit against their securities.

Moral Suasion:

Moral suasion implies persuasion, request, informal suggestion, advice and appeal by the central banks to commercial banks to cooperate with general monetary policy of the central bank.

In a situation of deficient demand leading to deflation, it appeals for credit expansion.

Selective Credit Controls (SCCs):

In this method, the central bank can give directions to the commercial banks not to give credit for certain purposes or to give more credit for particular purposes or to the priority sectors.

In a situation of deficient demand leading to deflation, the central bank withdraws rationing of credit and make efforts to encourage credit.

(b) Fiscal Policy: The expenditure and revenue policy taken by the general government to accomplish the desired goals is known as fiscal policy. A general government has to take the following steps:

Revenue Policy (Decrease in Taxes):

Revenue policy is expressed in terms of taxes.

During deflation, the government will impose lower amount of taxes so that purchasing power of the people be increased.

It is so because to control deficient demand we have to increase the amount of liquidity in the economy.

Expenditure Policy (Increase in Expenditure):

Government has to invest huge amount on public works like roads, buildings, irrigation works, etc.

During deflation, government should increase its expenditure on public works like roads, buildings, irrigation works thereby increasing the money income of the people and their demand for goods and services.

Decrease in Public Borrowing / Public Debt:

At the time of deficient demand, public borrowing should be reduced.

People will have more money and more purchasing power.

In brief, during period of deficient demand government should adopt the pricing of deficit budget.

Old taken debts from public should be finished and paid back to increase money in the market.