Question

Explain the problem of 'excess demand' in an economy with the he of a diagram. Explain the role of bank rate in correcting it.

Answer 1

EF indicates the excess demand or the inflationary gap.

Excess demand is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy. It implies two things-

1) Planned aggregate demand in the economy happens to exceed its full employment level.

2) The level of aggregate demand surpasses the level of aggregate supply even when the available factors are fully utilized.

Increase in bank rate: During inflation bank rate is increased. As a follow-up action, the commercial banks rise the market rate of interest. This reduces the demand for credit and thus inflation can be combated.