Income Determination Important Questions for class 12 economics Problems of Deficient and Excess Damand

1. Full Employment Equilibrium In an economy, when AS = AD or S = I alongwith fuller utilisation of labour force, the economy is said to be in full employment equilibrium.

2. Under Employment Equilibrium In an economy, when AS = AD or S = I but without the fuller utilisation of labour force, the economy is said to be in under employment equilibrium.

3. Full Employment A situation when all those who are willing to or able to work are getting work, is termed as full employment. Full employment never means zero unemployment in an economy, because there may always exist voluntary unemployment.

4. Voluntary Unemployment It is a kind of unemployment situation, when some people are not willing to work at all, or are not willing to work at the existing wage rate.

5. Involuntary Unemployment It is a situation in the economy, when even if people are willing to work at existing wage rates, they are not getting work.

6. Deficient Demand A situation when the Aggregate Demand is less than the Aggregate Supply in an economy, corresponding to full employment in the economy, is termed as deficient demand.
Deficient demand —> AS > AD, corresponding to full employment condition.

8. Deflationary Gap When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand from the level required to maintain a full employment equilibrium. This short fall is termed as deflationary gap.
EF is deflationary gap

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8. Causes of Deflationary Gap
(i) Reduction in private consumption expenditure.
(ii) Reduction in private investment expenditure.
(iii) Reduction in government consumption and investment expenditure.
(iv) Rise in imports.
(v)Reduction in exports.
(vi) Increase in tax burden on people.

9. Problems Due to Deficient Demand In case of deficient demand in an economy, AD < AS. It means all the goods and services produced in an economy cannot be sold at existing price levels. The inventory of producers start increasing and profits start shrinking with fall in price levels.

This results in low income or output and under employment in an economy. Thus, deficient demand causes deflation and under employment. The economy gets trapped in low income equilibrium.

10. Excess Demand The situation of an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full employment, it is termed as excess demand situation.
Excess demand —> AD > AS, corresponding to full employment level of output or income.

11. Inflationary Gap
The excess of Aggregate Demand above the level that is required to maintain full employment level of equilibrium is termed as inflationary gap.
In other words, when AD > AS it causes rise in prices and hence, leads to inflationary gap.

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12. Causes of Inflationary Gap
(i) Increase in private consumption expenditure (C).
(ii) Increase in private investment expenditure (I).
(iii) Increase in government consumption and investment expenditure(G).
(iv) Rise in exports (X).
(v) Reduction in imports (M).
(vi) Decrease in tax burden on people (T).

13. Problems Due to Excess Demand
In case of excess demand in an economy, AD > AS. It means the total demand for goods and services in an economy is more than that of production in the economy. Producers would start selling from their stocks to meet Aggregate Demand and hence, the inventory with producers starts decreasing and profits starts increasing with steep increase in price levels.
This results in high level of output and income. The price levels and wage rates will keep on increasing. Thus, excess demand causes inflation in an economy.

14. Measures for Correcting Deficient and Excess Demand
(i) Fiscal measures relates to fiscal policy of the government.
(ii) Monetary measures relates to monetary policy of the Central Bank.

15. Fiscal Policy
The revenue and expenditure policy of the government to correct the problem of deficient and excess demand is termed as fiscal policy.

16. Components of Fiscal Policy
(i) Government expenditure                       (ii) Taxes

17. Monetary Policy
The policy adopted by the Central Bank by regulating the cost of credit (i.e. rate of interest) and availability of credit (i.e. money supply) in the economy to control the problem of deficient and excess demand is termed as monetary policy.

18. Components of Monetary Policy
(i) Quantitative instruments or tools
(a) Bank rate
(b) Open market operations
• Open market purchases             • Open market sales
(c) Legal reserve requirements
• Cash Reserve Ratio (CRR)      • Statutory Liquidity Ratio (SLR)
(d) Repo rate and Reverse repo rate

(ii) Qualitative instruments or tools
(a) Margin requirement               (b) Selective credit control or rationing
(c) Moral suasion.

Previous Years Examination Questions

1 Mark Questions

1. Give the meaning of deflationary gap. (All India 2014; Delhi 2010,2008)
Ans. When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand from the level required to maintain a full employment equilibrium. This short fall is termed as deflationary gap.

2. Give the meaning of inflationary gap. (All India 2014,2010; Delhi 2008)
Ans. The excess of Aggregate Demand above the level that is required to maintain full employment equilibrium in an economy, is termed as inflationary gap.

3. What is meant by excess demand in macroeconomics?
                                                                                              (Foreign 2014; Delhi 2009)
or
Give the meaning of excess demand in an economy.    (All India 2009)
Ans. The situation of an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full employment, it is termed as excess demand situation.

4. Define involuntary unemployment. (Delhi 2014,2009; All India 2009)
or
What is involuntary unemployment?   (All lndia 2009; Delhi 2008)
Ans. Involuntary unemployment is a situation in the economy when even, if people are willing to work: at existing wage rates, they are not getting work.

5. Define full employment. (Delhi 2014,2009c, 2008; All India 2014)
Ans. A situation when all those who are willing to or able to work are getting work, is termed as full! employment in an economy.

6. Give the meaning of deficient demand. (Foreign 2014; All India 2008)
Ans. A situation when the Aggregate Demand is less than the Aggregate Supply in an. economy, corresponding to full employment, is termed as deficient demand.

7. What is under employment equilibrium? (Delhi 2008)
Ans. In an economy, when AS = AD or 5 = / but without the fuller utilisation of labour force, the economy is said to be in underemployment equilibrium.

3 Marks Questions

8. Explain the distinction between voluntary and involuntary unemployment. (All India 2011)
or
Distinguish between voluntary unemployment and involuntary unemployment.  (Delhi 2011C)
Ans. Voluntary unemployment is a kind of unemployment situation, when some people are not willing; to work at all or are not willing to work at the existing wage rate.
Involuntary unemployment is a situation in the economy when even if people are willing to work at: existing wage rates, they are not getting work.

9. What is the meaning and implications of deflationary gap?
                                                                                                         (All India 2011,2008)
or
In an economy, Aggregate Demand is less than Aggregate Supply. Explain the changes that will take place in this economy.  (All India 2011)
Ans. When there is involuntary unemployment in the economy, thereis a short fall in Aggregate Demand from the level required to maintain a full employment equilibrium.

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As a result of this producers will stop producing more and hence, income level will fall in the economy. The fall in Aggregate Supply will continue till the time, it again becomes equal to Aggregate Demand.

10. In an economy, Aggregate Demand is greater than Aggregate Supply. Explain the changes that will take place in this economy.   (Delhi 2011c)
Ans. When AD > AS in an economy, it will lead to inflationary pressure in the economy when price level and wage rate tends to rise. This inflationary gap encourages producers to increase their output to meet the excess demand. It will lead to gradual increase in income and output ultimately, Aggregate Supply will also increase to the point to be equal to Aggregate Demand.

11. Explain the problem of deficient demand in an economy. State two measures to solve it.   (Delhi 2008C)
Ans. A situation when Aggregate Demand fall short of Aggregate Supply at the full employment level of equilibrium is known as deficient demand.
(i) To solve this situation, government can reduce the tax rate, which will lead to an increase in the disposable income and in turn, consumption expenditure and Aggregate Demand will also increase.
(ii) Central Bank can reduce bank rate, which will lead to an increase in the money supply and income and Aggregate Demand will also increase.

 4 Marks Questions
12. Distinguish between inflationary gap and deflationary gap.
                                                                                                                     (All India 2012)
Ans. The excess of Aggregate Demand above the level that is required to maintain full employment level of equilibrium, is termed as inflationary gap. Inflationary gap causes inflation and increases wage and price levels in the economy.
When there is involuntary unemployment in the economy, there is a shortage in Aggregate Demand from the level required to maintain a full employment equilibrium. This short fall is termed as deflationary gap. Deflationary gap causes reduction in wage and prices in the economy.

13. Explain the concept of excess demand in macroeconomics. Also, explain the role of open market operation in correcting it. (Delhi 2012)
Ans. The situation in an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full employment level is termed as excess demand. In other words, the level of Aggregate Demand exceeds the level of Aggregate Supply even when there is full capacity production in the economy.

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In the above figure, £ is the point where AD = AS, i.e. equilibrium point. But at the present. Aggregate Demand ADae is more than the Aggregate Supply. Hence, EF represents the excess demand in the economy.
Excess demand leads to reduction in inventories and inflation in the economy. High prices encourage producers to produce more to reach the desired level of stock. Hence, the AS will also rise and economy will attain a new equilibrium at point G with National Income of OP.
Role of Open Market Operations to Correct the Problem of Excess Demand
Open market operations refer to sale and purchase of securities by the Central Bank on behalf of government in the open market. It directly affects the supply of money in the hands of citizens of the country. –
In case of excess demand, the Central Bank sells its securities to common public and financial institutions. It reduces the supply of money in the economy and reduces the money/credit creation power of commercial banks. Thus, the Aggregate Demand comes down and the economy attains equilibrium.

6 Marks Questions

14. Explain all the changes that will take place in an economy whenAggregate Demand is not equal to Aggregate Supply. (All India 2013)
Ans. (i) AD > AS When AD is greater than AS, flow of goods and services in the economy tends to be less than their demand. The existing stocks of the producers would be sold out. To rebuild the desired stocks the producer would plan greater production. AS would increase to become equal to AD.
(ii) AD < AS When AD is less than AS, flow of goods and services in the economy tends to exceed their demand. As a result, some of the goods would remain unsold. To clear unwanted stocks, the producers would plan a cut in production. Consequently, AS would reduce to become equal to AD. This is how AS adapts itself to AD

15. Explain the meaning of under employment equilibrium. Explain two measures by which full employment equilibrium can be reached.
                                                                                                                     (All India 2013)
Ans. In an economy, when AS = AD or S = I but without the fuller utilisation of labour force, the economy is said to be in under employment equilibrium.
Under employment equilibrium occurs when AS= AD but without the fuller utilisation of labour force.

Measures to Correct Under Employment Equilibrium
(i) Bank rate Central Bank should decrease the bank rate. A decrease in bank rate lowers the rate of interest and credit becomes cheap. Accordingly, the demand for credit expands and Aggregate Demand increases.
(ii) Open market operations By buying the government securities, the Central Bank injects additional purchasing power into the system which results in the expansion of credit. As a result Aggregate Demand increases.

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16. Explain the concept of deficient demand in macroeconomics. Also, explain the role of bank rate in correcting it. (Delhi 2012; All India 2011)

Ans. A situation in an economy, when the Aggregate Demand is less than the Aggregate Supply, corresponding to full employment level, is termed as deficient demand.

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Deficient demand gives rise to a deflationary gap and leads the economy to an equilibrium level of income/output that is less than the full employment level of income. This leads to deflationary pressures on economy and increases the inventory of producers as sales falls. The producers are discouraged to produce more as price level fall. The economy therefore will attain a new equilibrium at point C with National Income of OP
Role of Bank Rate in Correcting the Problem of Deficient Demand
The rate at which the Central Bank lends money to commercial banks is termed as bank rate. In case of deficient demand, the Central Bank reduces the bank rate to increase the money supply in the economy. Reduction in bank rate increases the credit/money creation capacity of commercial banks and also reduces the market rate of interest which encourages people to borrow more. In this way, the Aggregate Demand increases to the level of Aggregate Supply and the economy attains equilibrium.

17. Explain the concept of deflationary gap. Also, explain the role of margin requirement in reducing it. (All India 2012,2011,2010)
Ans. When there is involuntary unemployment in the economy, there is a short fall in Aggregate Demand from the level that is required to maintain a full employment equilibrium. This short fall is termed as deflationary gap.

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Role of Margin Requirements to Reduce Deflationary Gap Margin requirement refers to the difference between the amount of loan granted and the current value of security offered for loans. In case of deflationary gap, the margin requirements are lowered to increase the flow of credit by encouraging people to borrow. As a result of that, the Aggregate Demand increases and ultimately the economy attains equilibrium.

18. Explain the role of the following in correcting deficient demand in an economy.
(i) Open market operations
(ii) Bank rate          (Delhi 2012,2010)
Ans. (i) Role of open market operations in correcting deficient demand Open market operations refers to sale and purchase of securities by the Central Bank on behalf of government in the open market. It directly affects the supply of money in the hands of commercial banks and citizens of the country. In case of deficient demand, the Central Bank purchase securities from public.
It increases the supply of money in the economy as well as credit/money creation power of commercial banks. Thus, the Aggregate Demand increases and ultimately the economy attains equilibrium.
(ii) Role of bank rate In correcting deficient demand The rate at which the Central Banks lends money to commercial bank is termed as bank rate. In case of deficient demand, the Central Bank reduces the bank rate to increase the money supply in the economy.
Reduction in bank rate increases the money/credit creation power of commercial banks and also reduces the market rate of interest which encourages people to borrow more. In this way, the Aggregate Demand increases and ultimately the economy attains equilibrium.

19. Explain the role of the following in correcting excess demand in an economy
(i) Bank rate
(ii) Open market operations (Delhi 2011; All India 2011)
Ans. (i) Role of bank rate in correcting excess demand The rate at which the Central Bank lends money to commercial bank is termed as bank rate. In case of excess demand, the Central Bank increases the bank rate to decrease the supply of money in the economy. Increase in bank rate reduces the money creation power of commercial banks and also increases the market rate of interest which discourages public to borrow loans. The Aggregate Demand comes down and the excess demand is corrected.
(ii) Role of open market operations in correcting excess demand Open market operations refer to sale and purchase of government securities by the Central Bank in open market. In case of excess demand, the Central Bank sells the securities to public.
It reduces the supply of money and also reduces the credit creation power of commercial banks. In this way, the Aggregate Demand of economy comes down and the problem of excess demand is corrected.

20. Explain the concept of inflationary gap. Also, explain the role of legal reserves in reducing it.   (All India 2011,2010)
or
Define and represent inflationary gap on a diagram. Explain the role of the varying reserves requirement in removing the gap.   (Delhi 2010c)
or
Explain the concept of inflationary gap. Use diagram. Also, explain the role of legal reserve ratio in removing the gap.  (All India 2009)
Ans. (i) Inflationary gap occurs when AD > AS corresponding to full employment level. This inflationary gap i.e. excess of Aggregate Demand causes inflation in the economy and price levels tend to rise.

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(ii) Role of legal reserves to correct the problem of inflationary gap
Legal reserves like Cash Reserve Ratio and Statutory Liquidity Ratio are the tools to correct the problems of inflationary gap.
(i) Cash Reserve Ratio (CRR) Every commercial bank has to keep a certain proportion of its total demand and time deposits in the form of cash and other liquid assets with the Central Bank. This ratio is termed as cash reserve ratio. To correct the problem of inflationary gap the Central Bank increases the CRR. It reduces the supply of money and credit money creation capabilities of commercial banks. Due to lesser supply of money, the Aggregate Demand comes down and the economy attains equilibrium situation.
(ii) Statutory Liquidity Ratio (SLR) It refers to a fixed percentage of the total assets of a bank in the form of cash or other liquid assets that is required to be maintained by the bank with themselves. During the situation of inflationary gap, SLR is increased. This reduces the credit creation capacity of commercial banks and reduces the flow of money in the economy. As a result of that, the Aggregate Demand comes down and ultimately the economy attains equilibrium again.

21. Explain the meaning of equilibrium level of income. Can there be an unemployment in the economy at an equilibrium level of income? Explain.(Delhi 2008C)
Ans. Equilibrium level of income is the level at which Aggregate Demand is equal to Aggregate Supply in the. economy i.e. AD = AS. In other words, when desired output equals desired expenditure , equilibrium output or income is attained.
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