(b) 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).
(c) A simple example will further -clarify it. 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*).
2. ​Reasons or causes for excess demand​: The main reasons for excess demand are
apparently the increase in the following components of aggregate demand:
(a) Increase in household consumption demand due to rise in propensity to consume.
(b) Increase in private investment demand because of rise in credit facilities.
(c) Increase in public (government) expenditure.
(d) Increase in export demand.
(e) Increase in money supply or increase in disposable income.
3. ​Impacts or effects of excess demand on price, output, employment:
(a) 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.
(b) 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 can’t increase.
(c) Effect on Employment: There will be no change in thq. level of employment also.
The economy is already operating at full employment equilibrium, and hence, there is no
unemployment.
4. ​Measures to control the excess demand: We can control the excess demand with the
help of the following policy:
(a) Monetary Policy (b) Fiscal Policy
Let us discuss it in detail:
(a) ​Monetary Policy:​ Monetary policy is the policy of the central bank of a countiy to control
money supply and availability of credit in the economy. The central bank can take the following
steps:
(i) ​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 general 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.
-> So, 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
per cent, 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.
(ii) ​Qualitative Instruments or Selective Tools of Monetary Policy:​ These instruments are used to
regulate the direction of credit. They are as under:
(i) 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.
• So, 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.
(ii) 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.
(iii) 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:
(a) Revenue Policy (Increase Taxes):
(i) Revenue policy is expressed in terms of taxes.
(ii) During inflation the government impose higher amount of taxes causing the decrease in
purchasing power of the people.
(iii) It is so because to control excess demand we have to reduce the amount of liquidity from
the economy.
(b) Expenditure Policy (Reduces Expenditure):
(i) Government has to invest huge amount on public works like roads, buildings, irrigation works,
etc.
(ii) 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.
(c) ​Increase in Public Borrowing/Public Debt:
(i) 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.
(ii) So, government should resort to more public borrowing during excessive demand.
(iii) 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.