What is Excess Demand?

According to Keynesian theory, an equilibrium income level might correspond to full employment, underemployment, or over employment of resources. Similarly, when the economy is not at full employment, there will be instances of surplus demand and deficit demand. Excess demand and deficit demand are the two situations of disequilibrium.

Meaning of 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. It creates an inflationary gap. The inflationary gap is the excess of actual aggregate demand over the aggregate demand necessary to maintain full employment equilibrium. In short, the country’s overall demand is in excess of what is necessary to keep it at full employment. An inflationary gap leads to a rise in the price level or inflation because full employment has already been achieved, hence output and income levels cannot be raised. 

Excess Demand refers to the situation when Aggregate Demand (AD) is in excess of Aggregate Supply (AS) corresponding to full employment in the economy, i.e., AD>AS.

OR

When the actual level of aggregate demand is more than the required/ planned level of aggregate demand to maintain full employment.

The above figure illustrates the concepts of excess demand and inflationary gap. As shown in the diagram, aggregate demand is shown on the Y axis while income, output, and employment are shown on the X axis. The intersection of aggregate demand and supply, or point E, represents the full employment equilibrium. An increase in investment expenditure  causes the aggregate demand to rise from AD to AD₁. It describes a situation when there is excess demand, and the difference between them, or EF, is known as an inflationary gap. 

Reasons for Excess Demand

1. Rise in Consumption Expenditure (C):

Consumption expenditures are a significant part of Excess Demand. Excess demand can result from an increase in consumption expenditure due to an increase in the propensity to consume or a decrease in the willingness to save. Spending on private consumption may increase for several reasons. But, the increase in the propensity to consume or decrease in the propensity to save is the most crucial factor.

2. Tax Reduction: 

This may also happen as a result of lower taxes leading to more disposable income and an increase in consumer demand. Even though the consumer’s tendency to spend stays the same, it increases their capacity to spend.

3. Increase in Government Expenditure (G):

The government may increase its investment or consumption expenditure owing to budget requirements. A rise in government spending will lead to an increase in demand for products and services from the government, which will lead to excess demand.

4. Increase in Private Investment Expenditure (I): 

Private consumption expenditure is another significant part of Aggregate Demand. Excess demand can also occur when investment increases due to a fall in interest rates or an increase in projected returns.

5. Decline in Imports (M):

Imports may decline as a result of higher international prices than domestic prices, which may lead to excess demand.

6. Rise in Exports (X):

Exports refer to transferring of domestically produced goods to another country. When domestic goods are priced comparably lower than exports or when the value of the domestic currency declines, there may be excess demand.

7. Deficit Financing: 

It is a phenomenon where a government spends more money than it makes in taxes and covers up the deficit by borrowing money or creating additional funds. Excess demand may result from an increase in the money supply as a result of deficit financing.

Impact of Excess Demand

Excess demand is undesirable because it does not result in an increase in aggregate supply because the economy is already at full employment. The following impacts on output, employment, and the general price level are caused by excess demand:

1. Impact on Output:

As the economy is already at full employment and there is no idle capacity in the economy, excess demand has no impact on the level of output.

2. Impact on Employment: 

As the economy is currently functioning at full employment equilibrium and there is no involuntary unemployment, there will be no change in the level of employment.

3. Impact on the General Price Level: 

In case of excess demand, aggregate demand exceeds the aggregate supply, which results in an increase in the general price level of goods and services.