3 Measures to Rectify the Situation of Excess Demand

Some of the measures to rectify the situation of excess demand are: 1. Fiscal Policy, 2. Monetary Policy, 3. Miscellaneous!

1. Fiscal Policy:

Fiscal policy is the expenditure and revenue (taxation) policy of the government to accomplish the desired objectives.

In case of excess demand (when current demand is more than AS at full employment), the objective of fiscal policy is to reduce aggregate demand.

The main tools of fiscal policy are:

(i) Expenditure policy (Reduce expenditure):

In a situation like that of excess demand, government should curtail its expenditure on public works such as roads, buildings, rural electrification, irrigation works, thereby reducing the money income of the people and their demand for goods and services. In this way, government should reduce the budget deficit which shows excess of expenditure over revenue.

(ii) Revenue policy (increase taxes):

The other important part of fiscal policy is revenue policy which is expressed in terms of taxes. During inflation, government should raise rates of all taxes especially on rich people because taxation withdraws purchasing power from the tax­payers and to that extent reduces effective demand. Care should be taken that measures adopted to raise revenue should be disinflationary and at the same time have no harmful effects on production and savings. When government expenditure increases, AD of an economy increases by the same amount.

Here distinction is made between discretionary and non-discretionary measures used by the government. The non-discretionary elements refer to in-built stabilizers of income which operate automatically.

Progressive income-tax, grants, subsidies, old-age pension and others such as transfer payments are non-discretionary measures which operate automatically in both the situations of excess demand and deficient demand. As against it, discretionary measures refer to reduction in expenditures on public works, on public health and education, on defence and internal administration, etc.

(iii) Public borrowing (Increase it): Additionally, government should resort to large scale public borrowing to mop up excess money with the public.

(iv) Deficit financing (Reduce it):

At the same time, deficit financing (printing of currency/notes) should be cut down drastically because it leads to increase in demand Reducing deficit financing will reduce government ability to spend which, in turn .Will decrease AD in the economy. To keep deficit financing at safe limit, government may raise small savings such as PPF, NSC, etc. by offering incentives.

2. Monetary Policy (Raise bank rate and CRR):

Monetary policy is the policy of the central bank of a country to control money supply and credit in the economy. Therefore, it is also called Central Bank’s Credit Control Policy. Money broadly refers to currency notes and coins whereas credit generally means loans, i.e., finance provided to others at a certain rate of interest. Monetary measures (instruments) affect the cost of credit (i.e., rate of interest) and availability of credit. Thus, it helps in checking excess demand when credit availability is restricted and credit is made costlier.

Measures of monetary policy maybe (a) quantitative (which influence the total volume of credit) and (b) qualitative (which regulates flow of credit for specific uses) as explained below:

(a) Quantitative Measures:

(i) Bank rate or Repo rate (Increase bank rate):

Bank rate (Repo rate) is the rate of interest charged by central bank on loans given to commercial banks. Changing bank rate by central bank to influence credit availability is called Bank Rate Policy Mind, central bank lends to only commercial banks and not to general public.

In a situation of excess demand leading to inflation, the central bank raises bank rate which discourages commercial banks in borrowing from the central bank. Increase in bank rate forces commercial banks to increase their own lending rate of interest which makes credit cost her. As a result, the demand for loans falls.

Again, high rate of interest slows down the demand for goods and services and induces households to increase their savings by restricting expenditure on consumption and discourages investment. Thus, expenditure on investment and consumption is reduced.

This reduces credit creation by commercial banks. Remember, the rate of interest represents cost of money presently (Feb., 2013), Repo Rate (rate at which banks borrow from RBI) is 7.75% and Reverse Repo Rate (rate paid by RBI to commercial banks when the park their surplus funds with RBI) is 7.0%.

Rate of interest (D2004C):

Rate of interest is the rate charged by commercial banks on loans advanced to people. Rate of interest depends upon bank rate (Repo rate) i.e., higher the bank rate, higher will be interest rate.

(ii) Open Market Operation (Sell securities):

It refers to buying and selling of government securities and bonds in the open market by the central bank. This is done to influence the cash reserves with commercial banks. Sale by central bank brings flow of money to it from commercial banks thereby restricting their lending capacity.

Such operations affect amount of cash reserves with the commercial banks and their capacity to offer loans. During inflation, central bank sells government securities to commercial banks which lose equivalent amount of cash reserve thereby affecting their capacity to offer loans. Thus, it is an effective measure to control credit.

(iii) Cash-Reserve Ratio (Raise CRR) (02011, 12C):

It is the ratio (or fraction) of bank deposits that a commercial bank is required to keep with the central bank. Remember that every commercial bank is required under law to keep with the central bank a minimum proportion (say, 8 per cent) of its deposits as reserve in the form of cash. This is called Cash Reserve Ratio.

The bank is free to lend the remaining deposits. When there is an inflationary situation, the central bank raises the rate of minimum cash-reserve ratio thereby making the banks to keep more cash reserve with RBI which in turn curtails the lending capacity of commercial banks. RBI fixes rate of CRR according to market conditions. At present (Feb., 2013) CRR is 4.0%.

Statutory Liquidity Ratio (Raise SLR) (All; D12):

In addition to CRR, there is another measure called SLR according to which every bank is required to hold a certain minimum proportion of its total demand and time deposits in liquid form like liquid assets such as government securities. When RBI wants to contract credit or lending by banks, it increases SLR and thereby reduces credit availability. (On the contrary, when it wants to expand availability of credit, it lowers SLR.)

Legal Reserve Ratio [LRR) (A2011; D12):

LRR is a certain fraction of deposits which is legally compulsory for the commercial banks to keep as cash or in liquid form. There are two parts of this ratio—CRR and SLR as already explained above. When there is inflationary gap, RBI raises minimum limit of LRR so that lesser funds are available to banks for lending.

(b) Qualitative Measures:

(i) Moral Suasion (Restrict credit):

This refers to written or oral advice given by the central bank to commercial banks to restrict or expand credit.

During inflation, the central bank of a country employs selective credit control measures like moral suasion. For instance, it persuades its member banks not to advance credit for speculation or prohibit banks from entering into certain transactions. This advice is generally followed by member banks.

(ii) Margin Requirements (Increase it):

Margin requirement refers to the amount of security that banks demand from borrower of loan.

It is the difference between the amount of loan granted and the current value of security offered for taking loan. In a situation of excess demand, the central bank raises the limit of margin requirements. This discourages borrowing because it makes traders get less credit against their securities. On the other hand, in case of deficient demand, margin requirements are lowered to encourage borrowing.

Other measures of monetary policy are credit rationing, control of consumer credit, wage freeze and direct action.

3. Miscellaneous:

Other anti-inflationary measures can be: import promotion, wage freeze, control and blocking of liquid assets, compulsory savings scheme for households, increase in production by utilising idle capacities, etc.