Question

Explain the concept of 'excess demand' in macroeconomics. Also explain the role of 'open market operation' in correcting it.

Answer 1

Excess demand occurs in a situation when aggregate demand is more than aggregate supply corresponding to full employment. It leads to reduction in inventories and inflation in the economy. This situation is considered an inflationary gap—the difference between aggregate demand beyond full employment and aggregate demand at full employment. Aggregate demand is the AD curve and aggregate supply is the AS curve (as shown in the diagram below). While the aggregate demand curve and the aggregate supply curve intersect each other, the full employment equilibrium is attained at Point E. OY is the full
employment level of output, and EY is the aggregate demand at full employment level of output. If the aggregate demand increases beyond the full employment level of output from EY to FY, then the economy will have excess demand, i.e. situation of inflationary gap (FY − EY = FE).

 

Role of open market operation to curb the excess demand:

Open market operations refer to the sale and purchase of government securities and bonds by the central bank. While controlling inflation, the central bank sells government
securities to the public through the banks. This results in the transfer of a part of bank deposits to the central bank account and reduces credit creation capacity of the commercial banks.