Question

Suggest two monetary measures to correct excess demand in an economy.

Explain any one measure to correct excess demand in an economy.

Explain the various monetary measures by which excess demand in an economy can be checked?

Answer 1

Monetary policy can be effectively used to wipe out excess demand in the economy. Monetary policy is the policy of the central bank to control money supply and availability of credit in the economy to achieve various objectives of economic policy. More specifically, the central bank can use the instruments of bank rate, open market operations and cash reserve ratio to correct excess demand.

1. Bank Rate: Bank rate is the rate at which the central bank gives loans and advances to the commercial banks. To correct excess demand, there is the need to decrease bank credit. For this purpose, it is desirable to increase the bank rate. Increase in the bank rate would lead to a corresponding increase in the rate of interest charged by the commercial banks from their customers. The higher cost of borrowing from the commercial banks would reduce the amount of credit borrowed from them. As a result, consumption and investment expenditure financed through bank credit will fall.
2. Open Market Operations: Open market operations refer to the sale and purchase of government and other approved securities by the central bank to the commercial banks and other financial institutions. To wipe out excess demand in the economy, the central bank sells these securities to the commercial banks. This reduces the cash holdings of the commercial banks. This forces the commercial banks to reduce their loans and advances. As a result, expenditure financed through bank credit will fall, leading to a fall in aggregate demand.
3. Cash Reserve Ratio: Cash Reserve Ratio (CRR) is a direct, quick and effective method of controlling the power of commercial banks to give loans and advances. CRR is the ratio of bank deposits which the commercial banks are required to keep with the central bank. In a situation of excess demand, the central bank raises the CRR. This means that commercial banks are required to keep more cash with the central bank. As a consequence, the lending capacity of the commercial banks is reduced, thereby reducing consumption and investment expenditure financed through bank credit.