Question

What is Excess Demand ? Discuss its important causes.

Hint:

Remember that Excess Demand = Inflationary Gap. The causes are simply any factors that boost spending in the economy. Think about what would make households (C), firms (I), the government (G), or foreigners (X-M) want to buy more goods and services.

Answer 1

Excess Demand, also known as an inflationary gap, refers to a macroeconomic situation where the aggregate demand (AD) for goods and services in an economy is greater than the aggregate supply (AS) at the full employment level of output. In this situation, the economy is trying to spend more than it is capable of producing, as all resources are already fully employed. This excess pressure on demand leads to a persistent rise in the general price level, causing inflation.
The diagram below shows the AS curve (45-degree line) and two AD curves. ADF represents the aggregate demand required for full employment equilibrium at point E. ADE represents the actual (excess) aggregate demand. The vertical distance between ADE and ADF (gap EF) is the inflationary gap.

Important Causes of Excess Demand

Important Causes of Excess Demand:

Excess demand arises due to an increase in any of the components of aggregate demand (AD = C + I + G + (X-M)). The main causes are:

1. Increase in Consumption Expenditure (C): This can be due to:
   • A rise in the marginal propensity to consume (MPC) or a fall in the marginal propensity to save (MPS).
   • Increased availability of credit and lower interest rates, encouraging borrowing and spending.
2. Increase in Private Investment Expenditure (I):
   • Optimistic business expectations about future profits.
   • Lower interest rates, which make borrowing for investment cheaper.
3. Increase in Government Expenditure (G):
   • A rise in government spending on infrastructure, defense, or social welfare programs without a corresponding increase in taxes.
4. Increase in Net Exports (X-M):
   • A rise in exports due to higher demand from other countries or a fall in the exchange rate.
   • A fall in imports due to factors like higher tariffs.
5. Increase in Money Supply: An expansionary monetary policy (often called "printing money" or quantitative easing) increases the purchasing power in the economy, leading to higher aggregate demand.
6. Decrease in Taxes: Lower direct or indirect taxes leave households and firms with more disposable income, which can lead to higher consumption and investment.