Question

What is excess demand in an economy? Explain any measures to control it.
OR
Write the meaning of Involuntary Unemployment. Mention the factors responsible for Involuntary Unemployment.

Hint:

To distinguish the two macroeconomic problems: Excess Demand means "too much money chasing too few goods," leading to inflation. Deficient Demand (which causes involuntary unemployment) means "too little money chasing too many goods," leading to recession and unemployment.

Answer 1

Step 1: Meaning of Excess Demand:
Excess Demand, also known as an inflationary gap, is 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. \[ AD > AS \text{ (at full employment)} \] Since the economy is already operating at its maximum potential (full employment), this excess demand cannot be met by an increase in output. Instead, it pulls the general price level upwards, leading to inflation.

Step 2: Measures to Control Excess Demand:
The primary objective of policy measures is to reduce the Aggregate Demand to bring it in line with Aggregate Supply. This can be achieved through two main policies: \begin{enumerate} \item Fiscal Policy (by the Government): \begin{itemize} \item Decrease in Government Spending: The government can reduce its own expenditure on public works, defense, and other projects. This directly reduces the 'G' component of AD (\(AD = C+I+G+X-M\)). \item Increase in Taxes: The government can increase both direct taxes (like income tax) and indirect taxes. This reduces the disposable income of households and the post-tax profits of firms, leading to a decrease in consumption (C) and investment (I), thereby reducing AD. \end{itemize} \item Monetary Policy (by the Central Bank): \begin{itemize} \item Increase in Bank Rate/Repo Rate: The central bank makes borrowing more expensive for commercial banks. This forces commercial banks to increase their own lending rates, which discourages borrowing by the public for consumption and investment, thus reducing AD. \item Open Market Operations (Selling Securities): The central bank sells government securities in the open market. This absorbs excess liquidity from the financial system, reducing the lending capacity of commercial banks and curbing AD. \item Increase in Legal Reserve Ratios (CRR/SLR): By increasing the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), the central bank reduces the funds available with commercial banks for lending, which contracts credit and reduces AD. \end{itemize} \end{enumerate}

Step 3: Final Answer:
Excess demand occurs when aggregate demand exceeds aggregate supply at the full employment level, causing inflation. It can be controlled by contractionary fiscal policies (reducing government spending, increasing taxes) and contractionary monetary policies (increasing interest rates, selling securities).

Solution (Involuntary Unemployment):

Step 1: Meaning of Involuntary Unemployment:
Involuntary Unemployment refers to a situation where people are able and willing to work at the prevailing market wage rate but are unable to find employment. It is a state where there are job-seekers but not enough jobs available for them.
This is distinct from voluntary unemployment, where individuals choose not to work at the existing wage rate. Involuntary unemployment is a sign of a malfunctioning economy and is the primary concern of macroeconomic policy. According to Keynesian economics, it arises primarily due to a deficiency in aggregate demand.

Step 2: Factors Responsible for Involuntary Unemployment:
The major factors responsible for causing involuntary unemployment are: \begin{enumerate} \item Deficiency of Aggregate Demand (Keynesian View): This is the most significant cause. If the total demand for goods and services in the economy is low, firms will cut back on production and will not need to hire all the available workers. This deficiency can be due to: \begin{itemize} \item Low Private Consumption (C): Caused by high savings rates or low consumer confidence. \item Low Private Investment (I): Caused by poor business expectations, high interest rates, or low profitability. \end{itemize} \item Cyclical Factors: Involuntary unemployment rises sharply during the recessionary or depression phase of a business cycle when overall economic activity slows down. \item Structural Factors: \begin{itemize} \item Technological Changes: Automation and labor-saving technologies can make certain types of labor redundant. \item Mismatch of Skills: A gap between the skills possessed by the workforce and the skills demanded by employers can lead to unemployment even when vacancies exist. \end{itemize} \item High Labor Costs: If wage rates are rigid and fixed above the market-clearing level (due to minimum wage laws or powerful trade unions), the demand for labor by firms may be less than the supply of labor, causing unemployment. \item Slow Economic Growth: In a developing economy, if the rate of economic growth is not fast enough to absorb the new entrants into the labor force each year, unemployment will rise. \end{enumerate}

Step 3: Final Answer:
Involuntary unemployment is a situation where people willing to work at the prevailing wage cannot find jobs. The primary causes include a deficiency of aggregate demand, structural changes in the economy like technological shifts, cyclical downturns (recessions), and wage rates being too high.