Excess and Deficient Demand in Three-Sector Economy

Excess and Deficient Demand in Three-Sector Economy

When demand is more than what is necessary to utilise resources fully, it is called Excess Demand. However, when demand is not sufficient to fully utilise resources, it is referred to as Deficient Demand. Excess Demand and Deficient Demand can occur in a three-sector economy (which includes households, firms, and government). In a three-sector economy, Aggregate Demand (AD) is the sum total of Consumption (C), Investment (I), and Government Expenditure (G). Because of the introduction of the government sector, the new AD₁ curve; i.e., C+I+G lies above the old curve AD; i.e., C+I. To make things simple, it is assumed that government expenditure is constant because of which the new AD₁ curve is parallel to the old AD curve, as the vertical distance between them is G. 

The effect of Government Expenditure can be shown with the help of the following graph:

Note: Earlier, we discussed in excess demand and deficient demand that AD only includes Consumption and Investment. However, the inclusion of Government Expenditure does not have any impact on the nature or meaning of excess demand and deficient demand.

Remedy for Excess Demand and Deficient Demand

The government has taken different measures to correct the problem of excess and deficient demand in a three-sector economy.

Remedy for Excess Demand

The government can correct the problem of excess demand by reducing the aggregate demand by an amount, that is, equal to the inflationary gap.

In the above graph, F is the equilibrium point that is attained when the AD curve intersects the AS curve. To correct the problem of the inflationary gap, the government uses its fiscal measure and reduces expenditure. A reduction in government expenditure will reduce aggregate demand and remove the inflationary gap. Therefore, when there is a reduction in the government expenditure by  the AD curve shifts downward to AD₁. Now, the new aggregate demand level is AD₁, which is sufficient enough to keep the economy at full employment equilibrium; i.e., point E.

Remedy for Deficient Demand

The government can correct the problem of deficient demand by increasing the aggregate demand by an amount that is equal to the deflationary gap. 

In the above graph, F is the equilibrium point that is attained when the AD curve intersects the AS curve. However, the equilibrium point here signifies the underemployment equilibrium level and EG is the resulting deflationary gap. So, to correct this deflationary gap, the government uses its fiscal measure and increases expenditure. When the government expenditure is increased, the new aggregate demand level is AD₁ which corresponds to a higher level of government expenditure. The new AD curve; i.e., AD₁ is sufficient enough to keep the economy at full employment equilibrium; i.e., point E.