Measure to Correct Excess Demand(Inflationary Gap)

Measure to Correct Excess Demand

FISCAL MEASURE

1.Increase Taxes
Government impose higher amount of taxes causing the decrease in purchasing power of the people.
2.Decrease in Government Spending: government should reduce its expenditure on public works thereby reducing the money income of the people and their demand for goods and services.
3. Increase in Public Borrowing/Public Debt:
 This measure means that government should raise loans from public and hence borrowing decreases the purchasing power of people by leaving them with lesser amount of money.

MONETARY MEASURE

Two major instruments of Monetary Policy, used to decrease availability of credit are:
(i) Quantitative Instruments;
(ii) Qualitative Instruments.

Quantitative Measure

1. Increase in Bank Rate:

The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks .During excess demand, central bank increases the bank rate, which discourages borrowers from taking loans. It reduces the availability of credit in the economy and helps to correct excess demand.

Increase in Repo Rate
Repo rate is the rate at which commercial banks borrow money from the central bank for short period .
Central bank raises repo rate that discourages commercial banks in borrowing from central bank .It forces the commercial banks to increase their lending rates, which discourages borrowers from taking loans, which
discourages investment.

Increase in Reverse Repo Rate:
It is the rate at which the central bank (RBI) borrows money from commercial bank.
 In a situation of excess demand
Reverse repo rate is increased, it encourages the commercial bank to park their funds with the central bank .It decreases the lending capability of commercial banks, which controls excess demand.
2. Open Market Operations (Sale of securities):
Open market operations refer to sale and purchase of securities in the open market by the central bank.During excess demand, central bank offers securities for sale. It adversely affects the bank’s ability to create credit and decreases the level of aggregate demand in the economy.
3. Increase in Legal Reserve Requirements (LRR):
There are two components of legal reserves:
(i) Cash Reserve Ratio (CRR)
It is the minimum percentage of net demand and time liabilities, to be kept by commercial banks with the central bank.
(ii) Statutory Liquidity Ratio (SLR):
It refers to minimum percentage of net demand and time liabilities, which commercial banks are required to maintain with themselves.
To correct the excess demand, the central bank increases CRR or/and SLR. It reduces the amount of effective cash resources of commercial banks and limits their credit creating power. It ultimately helps in reducing credit availability in the economy.

(ii) Qualitative Instruments:

1.Increase in Margin Requirements:
Margin requirement refers to difference between the market value of security offered and the value of amount lent. When the economy is suffering from excess demand, central bank increases the margin. Borrowers find it less attractive to borrow money and it decreases the level of aggregate demand.

2. Moral Suasion (Advice to Discourage Lending):
During excess demand, the central bank advises, requests or persuades the commercial banks not to advance credit for speculative or non¬essential activities.It helps to reduce availability of credit and aggregate demand.

3. Selective Credit Controls (Introduce Credit Rationing):
 During excess demand, the central bank introduces rationing of credit in order to prevent excessive flow of credit, particularly for speculative activities. It helps to wipe off the excess demand.