Notes

Part 2

(b) 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).
(c) 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 quin tals, 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.
2. ​Reasons or causes for deficient demand:​ The main reasons for deficient demand are
apparently the decrease in four components of aggregate demand:
(a) Decrease in household consumption demand due to fall in propensity to consume.
(b) Decrease in private investment demand because of fall in credit facilities.
(c) Decrease in public (government) expenditure.
(d) Decrease in export demand.
(e) Decrease in money supply or decrease in disposable income.
3. ​Impacts or effects of deficient demand:
(a) 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.
(b) 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.
(c) Effect on Output: Low level of investment and employment implies low level of output.
4. Measures to Control the deficient demand: We can control the deficient demand with the help
of the following policies:
(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 country of controlling
money supply and availability of credit in the economy. The central bank takes 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 (Decrease 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 deficient demand leading to deflation,
❖ Central bank decreases bank rate that encourages commercial banks in borrowing from
central bank as it will decrease the cost of borrowing of commercial bank.
❖ Decrease in bank rate makes commercial bank to decrease their lending rates, which
encourages borrowers from taking loans, which encourages investment.
❖ Again low rate of interest induces households to decrease their savings by increasing
expenditure on consumption.
❖ Thus, expenditure on investment and consumption increase, which will control the deficient
demand.
• Repo Rate (Decrease 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 deficient demand leading to deflation,
❖ Central bank decreases Repo rate that encourages commercial banks in borrowing from
central bank as it will decrease the cost of borrowing of commercial bank.
❖ Decrease in Repo rate makes commercial banks to decrease their lending rates, which
encourages borrowers from taking loans, which encourages investment.
❖ Again low rate of interest induces households to decrease their savings by increasing
expenditure on consumption.
❖ Thus, expenditure on investment and consumption increase, which will control the deficient
demand.
• Reverse Repo Rate (Decrease Reverse Repo Rate):
-> It is the rate at which the central bank (RBI) borrows money from commercial bank.
-> In a situation of deficient demand leading to deflation, Reverse repo rate is decreased, it
discourages the commercial bank to park their funds with the central bank. It increases the
lending capability of commercial banks, which controls deficient demand.
• Open Market Operation (Purchase of Securities):
-> It consists of buying and selling of government securities and bonds in the open market by
central bank.
-> In a situation of deficient demand leading to deflation, central bank purchases government
securities and bonds from commercial bank. With the purchase of these securities, the power of
commercial bank of giving loans increases, which will control deficient demand.
• Decrease in Varying Reserve Requirements:
-> 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 (Decrease):
❖ It refers to the minimum percentage of a bank’s total deposits, which 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 deficient demand leading to deflation, cash reserve ratio (CRR) falls to 5 per
cent, the bank will have to keep Rs. 5 crore with the central bank, which will increase the cash
resources of commercial bank and increasing credit availability in the economy, which will
control deficient demand.
-> The Statutory Liquidity Ratio (SLR) (Increase):
❖ 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 deficient demand leading to deflation, the central bank decreases statutory
liquidity ratio (SLR), which will increase the cash resources of commercial bank and increases
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:
• Imposing margin requirement on secured loans( Decrease):
-> 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 deficient demand leading to deflation, central bank decreases marginal
requirements. This encourages borrowing because it makes people get more credit against their
securities.
• 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 deficient demand leading to deflation, it appeals for credit expansion.
• Selective Credit Controls (SCCs):
-> 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 deficient demand leading to deflation, the central bank withdraws rationing of
credit and make efforts to encourage credit.
2. 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 has to take the
following steps:
(a) Revenue Policy (Decrease in Taxes):
(i) Revenue policy is expressed in terms of taxes.
(ii) During deflation the government will impose lower amount of taxes so that purchasing power
of the people be increased.
(iii) It is so because to control deficient demand we have to increase the amount of liquidity in
the economy.
(b) Expenditure Policy (Increase in Expenditure):
(i) Government has to invest huge amount on public works like roads, buildings, irrigation works,
etc.
(ii) During deflation government should increase its expenditure on public works like roads,
buildings, irrigation works thereby increasing the money income of the people and their demand
for goods and services.
(c) Decrease in Public Borrowing / Public Debt:
(i) At the time of deficient demand public borrowing should be reduced.
(ii) People will have more money and more purchasing power.
(iii) In brief, during period of deficient demand government should adopt the pricing of deficit
budget.