Excess and deficient demand
Inflationary and deflationary gaps and measures to correct them.
The essentials
Full employment is a situation where everyone willing and able to work at the prevailing wage gets work; only frictional or voluntary unemployment remains.
Excess demand occurs when aggregate demand is more than aggregate supply at the full-employment level of output. Since output cannot rise further, the extra demand pushes up prices. The amount by which AD exceeds AS at full employment is the inflationary gap.
Deficient demand occurs when AD is less than AS at full employment. Output and employment fall, causing involuntary unemployment. The shortfall is the deflationary gap.
Measures to correct the gaps
- Fiscal policy (government): to cut excess demand, reduce government spending and raise taxes; to cure deficient demand, increase spending and cut taxes.
- Monetary policy (RBI): to cut excess demand, raise repo rate, bank rate, CRR or SLR, sell securities and raise margin requirements; to cure deficient demand, do the opposite.
- Measures should be applied with care because of the multiplier: a small change in spending has a larger effect on income.
Key points
- Inflationary gap = AD at full employment − AS at full employment.
- Deflationary gap = AS at full employment − AD at full employment.
- Excess demand mainly causes inflation, not higher real output, once full employment is reached.
Exam tips
Always identify whether the gap is inflationary or deflationary first, then list fiscal and monetary measures in the right direction.
Common mistakes
- Saying excess demand causes unemployment.
- Recommending higher taxes to cure deficient demand.