Question

What is 'excess demand'? Explain the role of 'Reverse Repo Rate' in removing it.

Answer 1

1. When in an economy, aggregate demand exceeds "aggregate supply at full employment level", the demand is said to be an excess demand.

2. It can be explained with the help of following diagram:

Ref. image

3. (i) Reverse Repo Rate is the rate at which the central bank (RBI) borrows money from commercial bank

(ii) In a situation of excess demand leading to inflation, Reverse repo rate is increased, it encourages the commercial bank to park their funds with the central bank to earn higher return on idle cash. It decreases the lending capability of commercial banks, which controls excess demand.