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.

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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.

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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: