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How to Control Excess Demand?

Last Updated : 06 Apr, 2023
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Measures to control Excess Demand

When demand is more than what is necessary to utilise resources fully, it is called Excess Demand. In simple terms, when planned aggregate expenditure is more than aggregate supply at full employment, excess demand arises. 

The problem of excess demand arises when the current aggregate demand exceeds the aggregate demand required for full employment equilibrium. It occurs due to an increase in the money supply and easy access to credit. A change in the level of the economy’s aggregate demand can be used to solve this problem. There are several ways that can be used to correct excess demand such as:

1. Decrease in Government Spending:

Government spending is a significant component of aggregate demand. This action, which the government refers to as its Expenditure Policy, is a component of its fiscal policy. Government invests a significant amount of money in developing things like highways, flyovers, buildings, railway lines, etc. A change in such spending has a direct impact on the amount of aggregate demand in the economy and helps in the management of excess and deficient demand conditions. Government spending should be as low as possible in order to manage the condition of excessive demand. Greater attention should be placed on reducing defence and unproductive expenditures, as these rarely contribute to a country’s growth. Reduced government spending serves to lessen inflationary pressures in the economy by lowering the level of aggregate demand.

2. Increase in Taxes:

Taxes are the government’s principal source of income. This measure is an element of Fiscal Policy and is described as the Revenue Policy of the Government. The government charges many types of direct and indirect taxes on the general public. Government Tax changes have a direct impact on the level of total demand and help in balancing excess and deficient demand in the economy. Government raises tax rates and even imposes some additional taxes during periods of excess demand. It results in a decline in total economic spending and helps in managing the condition of excessive demand.

3. Decrease in Money Supply/Accessibility of Credit:

With the help of its Monetary Policy, the Reserve Bank of India (RBI) is able to control the money supply in the economy. It is a policy used by the Central Bank of an economy to control the amount of credit or the money supply. The Central Bank (RBI) seeks to limit the availability of credit in the economy through its Monetary Policy. Two major instruments of Monetary Policy are:

(I) Quantitative Instruments

These instruments are designed to increase the total volume of credit that is in existence. The principal tools or measures are:

1. Increase in Bank Rate: Bank Rate refers to the rate at which the central bank lends money to commercial banks in order to satisfy their long-term requirements. The cost of borrowing money from the central bank increases when there is an increase in the bank rate. It drives commercial banks to raise lending rates, preventing potential borrowers from taking out loans. It helps to adjust for excess demand and lowers the amount of credit available in the economy.

2. Increase in Repo Rate: Repo Rate is the interest rate at which the central bank loans money to commercial banks to cover their short-term requirements. The central bank increases the repo rate to decrease the availability of credit during periods of excess demand. As a result, commercial banks are compelled to raise their lending rates. It prevents borrowers from taking out loans and decreases the amount of credit available in the market, which helps in reducing excess demand.

3. Rise in Reverse Repo Rate: This is the interest rate at which commercial banks can deposit excess funds with the Central Bank for a shorter period of time. The Central Bank may raise the Reverse Repo Rate to solve the problem of excess demand. It motivates Commercial Banks to deposit their excess cash with the Central Bank. It will decrease the ability of commercial banks to lend money. Due to this, investment and consumption spending may decline, which would decrease aggregate demand.

4. Open Market Operations or Sale of Securities: The selling and purchasing of securities in the open market by the central bank are referred to as Open Market Operations. It has a direct impact on the economy’s money supply. When there is an excess of demand, the central bank sells securities. The reserves of commercial banks are decreased through the sale of securities. It has a negative impact on the bank’s ability to extend credit and reduces aggregate demand in the economy.

5. Increase in Legal Reserve Requirements: Commercial banks are required to keep legal reserves. A rise in these reserves is a direct way to limit credit availability. Legal Reserves consist of two parts:

  • Cash Reserve Ratio (CRR): It is the minimum amount of net demand and time liabilities that commercial banks are required to maintain with the central bank.
  • Statutory Liquidity Ratio (SLR): This term refers to the minimum proportion of net demand and time liabilities that commercial banks must keep on hand. 

The central bank raises CRR or/and SLR to reduce excess demand. It diminishes commercial banks’ effective cash resources and reduces their ability to create loans. In the end, it helps in limiting the amount of credit available to the economy.

(II) Qualitative Instruments 

These tools are designed to control the flow of credit. The important qualitative tools or measures are:

1. Increase in Margin Requirements: The term Margin Requirement describes the difference between the market value of the offered security and the value of the amount lent. When there is excess demand in the economy, the central bank raises the margin, which limits the ability of banks to create credit. As a result, borrowing becomes less attractive to borrowers, which reduces aggregate demand.

2. Moral Suasion (Advice to Discourage Lending): The Central Bank uses a combination of persuasion and pressure to convince other banks to act in a way that is consistent with its policy. Discussions, letters, lectures, and tips to banks are used to exercise moral persuasion. The central bank advises, requests, or persuades commercial banks not to provide credit for speculative or non-essential purposes when there is an excess of demand.

3. Selective Credit Controls (Introduce Credit Rationing): This technique involves the central bank instructing other banks to provide or refuse credit to specific sectors for a given set of purposes. In times of excess demand, the central bank imposes credit rationing to stop excessive credit flow, especially for speculative activity. It helps in removing the excessive demand.


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