Question

How can ‘excess demand’ be tackled?

Answer 1

1. Fiscal Policy: Fiscal policy can successfully reduce surplus demand. Fiscal policy is the government's policy that uses taxation, public expenditure, and public borrowing to achieve various economic policy goals.
   1. Taxation: The government can utilize taxation to address excess demand. The government should levy new taxes and increase the rates of existing taxes. An rise in direct taxes, particularly on the wealthiest, reduces disposable income, resulting in a fall in consumption expenditure. Similarly, an increase in business (corporation) taxes, particularly on the business sector that invests in creating luxury, will result in a decrease in investment.
   2. Public Expenditure: To eliminate surplus demand, the government should reduce its spending, particularly on unproductive and non-development activities such as defense and administration. A reduction in government spending on goods and services reduces excess demand immediately.
   3. Public Borrowing: The government should also embrace a program of large-scale public borrowing. This will absorb extra purchasing power among the public.
   4. Deficit Financing: Deficit financing (the policy of creating new money to cover the difference between government expenditure and revenue) must be significantly reduced. Reducing deficit finance will limit the government's ability to spend. As a result, aggregate demand will decline.
2. Monetary Policy: Monetary policy can be used effectively to reduce excess demand in the economy. Monetary policy is the central bank's policy of controlling the money supply and credit availability in the economy in order to achieve various economic policy objectives. To adjust excess demand, the central bank can employ instruments such as the bank rate, open market operations, and cash reserve ratio.
   1. Bank Rate: The bank rate is the rate at which the central bank makes loans and advances to commercial banks. To address excess demand, bank credit needs to be reduced. For this reason, it is preferable to raise the bank rate. Increases in the bank rate would result in equal increases in the interest rates paid by commercial banks to their customers. The increased cost of borrowing from commercial banks would limit the quantity of credit obtained from them. As a result, consumption and investment spending financed with bank loans will decline.
   2. Open Market Operations: Open market operations are the sales and purchases of government and other sanctioned securities by the central bank to commercial banks and other financial institutions. To reduce excess demand in the economy, central banks sell these assets to commercial banks. This diminishes the cash holdings of commercial banks. This forces commercial banks to lower loans and advances. As a result, bank credit-financed expenditure will reduce, causing aggregate demand to shrink.
   3. Cash Reserve Ratio: The Cash Reserve Ratio (CRR) is a straightforward, rapid, and effective technique of managing commercial banks' ability to make loans and advances. CRR is the ratio of bank deposits that commercial banks are required to maintain with the Central Bank. In the event of excessive demand, the central bank raises the CRR. This means that commercial banks must hold more cash at the central bank. As a result, commercial banks' lending capacity is lowered, lowering consumption and investment expenditures financed by bank credit.
3. Increasing Imports: The issue of excess demand can be addressed by boosting aggregate supply in the economy through imports of products and services. An rise in imports increases the availability of products and services in an economy, reducing surplus demand.
4. Increase in Output: Excess demand can be mitigated by boosting domestic output. However, the ability to increase domestic output in the short run is restricted. This measure is more efficient in the long run.