Question

What is 'excess demand' in macroeconomics? Show the same in a diagram. Explain the role of 'open market operations' in reducing it.

Answer 1

In the above diagram, EF is termed as excess demand. 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.

Open market operation is the policy that focuses on increasing and decreasing the stock of liquidity with the people, through sale and purchase of securities by the central bank. During excess demand or inflation, the central bank tries to sale securities. Sale of securities reduces purchasing power from the market. Consequently, aggregate demand is decreased and excess demand or inflationary gap gets combated.