Explain the concept of ‘deficient demand’ in macroeconomics. Also explain the role of Bank Rate in correcting it.
Deficient demand refers to the situation when aggregate demand (AD) is less than the aggregate supply (AS) corresponding to full employment level of output in the economy.
The situation of deficient demand arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap. Deflationary gap is the gap by which actual aggregate demand falls short of aggregate demand required to establish full employment equilibrium.
Reasons for deficient demand:
1. Decrease in Propensity to consume: A decrease in consumption expenditure, due to fall in the propensity to consume, leads to deficient demand in the economy.
2. Increase in taxes: AD may also fall due to imposition of higher taxes. It leads to decrease in disposable income and, as a result, the economy suffers from deficient demand.
3. Decrease in Government Expenditure: When government reduces its demand for goods and services due to fall in public expenditure, it leads to deficient demand.
4. Fall in Investment expenditure: Increase in the rate of interest or fall in the expected returns lead to decrease in the investment expenditure. It reduces the AD and gives rise to deficient demand.
5. Rise in Imports: When international prices are comparatively less than the domestic prices, then it may lead to a rise in imports, implying a cut in the aggregate demand.
6. Fall in Exports: Exports may fall due to comparatively higher prices of domestic goods or due to increase in the exchange rate for domestic currency. This will lead to deficient demand.
Role of Bank Rate in Correcting Deficit Demand:
The term ‘Bank Rate’ refers to the rate at which central bank lends money to commercial banks as the lender of last resort. During deficient demand, the central bank reduces the bank rate in order to expand credit. It leads to fall in the market rate of interest which induces people to borrow more funds. It ultimately leads to increase in the aggregate demand.
Explain the process of money creation by the commercial banks with the help of a numerical example.
Process of Creation of Money:
The process of money creation by the commercial banks starts as soon as people deposit money in their respective bank accounts. After receiving the deposits, as per the central bank guidelines, the commercial banks maintain a portion of total deposits in form of cash reserves. The remaining portion left after maintaining cash reserves of the total deposits is then lend by the commercial bank to the general public in form of credit, loans and advances. Now assuming that all transactions in the economy are routed through the commercial banks, then the money borrowed by the borrowers again comes back to the banks in form of deposits. The commercial banks again keep a portion of the deposits as reserves and lend the rest. The deposit of money by the people in the banks and the subsequent lending of loans by the commercial banks is a never-ending process. It is due to this continuous process that the commercial banks are able to create credit money a multiple time of the initial deposits.
The process of creation of money is explained with the help of the following numerical example.
|Rounds||Deposits Received||Loans Extended||Cash Reserves|
Suppose, initially the public deposited Rs 10,000 with the banks. Assuming the Legal Reserve Ratio to be 20%, the banks keep Rs 2,000 as minimum cash reserves and lend the balance amount of Rs 8,000 (Rs 10,000 – Rs 2,000) in form of loans and advances to the general public.
Now, if all the transactions taking place in the economy are routed only through banks then, the money borrowed by the borrowers is again routed back to the banks in form of deposits. Hence, in the second round there is an increment in the deposits with the banks by Rs 8,000 and the total deposits with the banks now rises to Rs 18,000 (that is, Rs 10,000 + Rs 8,000). Now, out of the new deposits of Rs 8,000, the banks will keep 20% as reserves (that is, Rs 1600) and lend the remaining amount (that is, Rs 6,400). Again, this money will come back to the bank and in the third round, the total deposits rises to Rs 24,400 (i.e. Rs 18,000 + Rs 6,400).
The same process continues and with each round the total deposits with the banks increases. However; in every subsequent round the cash reserves diminishes. The process comes to an end when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become equal to the initial deposits of Rs 10,000 that were initially held by the banks. As per the above schedule, with the initial deposits of Rs 10,000, the commercial banks have created money of Rs 50,000.
Government of India has recently launched 'Jan-Dhan Yojna' aimed at every household in the country to have at least one bank account. Explain how deposits made under the plan are going to affect national income of the country.
With the Jan Dhan Yojna a greater number of individuals are brought under the ambit of banking system. Those individuals who earlier did not have savings account now have access to banking facilities and have opened savings account with the commercial banks.
In this way, the commercial banks are able to tap greater savings which in turn can be used to lend loans for investment purposes. Thus, the yojna indirectly helps in increasing the investment and production in the economy which in turn would help in improving the national income.
Explain the 'bank of issue' function of the central bank.
Explain 'Government's Bank' function of central bank.
The central bank is the bank of issue. It has the monopoly of note issue. Notes issued by it circulate as legal tender money. It has its issue department which issues notes and coins to commercial banks. Coins are manufactured in the government mint but they are put into circulation through the central bank.
However, the currency issued by the central bank is its monetary liability. In other words, the central bank is obliged to back the currency issued by it by assets of equal value such as gold coins and bullions, foreign exchange. In addition to issuing currency to the general public, the central bank also issues currency to the central government of the country.
Central banks act as bankers, fiscal agents and advisers to their respective governments. As a banker to the government, the central bank keeps the deposits of the central and state governments and makes payments on behalf of governments. But it does not pay interest on governments deposits. It buys and sells foreign currencies on behalf of the government. It keeps the stock of gold of the government. Thus it is the custodian of government money and wealth. As a fiscal agent, the central bank makes short-term loans to the government for a period not exceeding 90 days. It floats loans, pays interest on them, and finally repays them on behalf of the government. Thus it manages the entire public debt. The central bank also advises the government on such economic and money matters as controlling inflation or deflation, devaluation or revaluation of the currency, deficit financing, balance of payments, etc.
Explain the concept of ‘excess demand’ in macroeconomics. Also explain the role of ‘open market operation’ in correcting it.
Excess demand refers to the situation when aggregate demand (AD) is more than the aggregate supply (AS) corresponding to full employment level of output in the economy. It is the excess of anticipated expenditure over the value of full employment output.
Due to the excess of aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as inflationary gap. This gap measures the amount of surplus in the level of aggregate demand. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF). In the figure, EY denotes the aggregate demand at the full employment level of output and FY denotes the actual aggregate demand. The vertical distance between these two represents inflationary gap.
Following are the reasons for Excess Demand:
1. Rise in the Propensity to consume: Excess demand may arise because of increase in consumption expenditure due to rise in the propensity to consume or fall in propensity to save.
2. Reduction in taxes: It may also occur due to increase in disposable income and consumption demand because of decrease in taxes.
3. Increase in Government Expenditure: Rise in government demand for goods and services due to increase in public expenditure will also result in excess demand.
4. Increase in Investment. Excess demand can also arise when there is increase in investment due to decrease in rate of interest or increase in expected returns.
5. Fall in Imports: Decrease in imports due to higher international prices in comparison to domestic prices may also lead to excess demand.
6. Rise in Exports: Excess demand may also arise when demand for exports increases due to comparatively lower prices of domestic goods or due to decrease in the exchange rate for domestic currency.
Role of Open Market Operation in curbing the Excess Demand:
In order to curb the problem of excess demand, the government can opt for open market operations (OMO). Open market operations refer to sale and purchase of securities in the open market by the central bank. It directly influences the level of money supply in the economy. During excess demand, central bank offers securities for sale. Sale of securities reduces the reserves of commercial banks. It adversely affects the bank’s ability to create credit and decreases the level of aggregate demand in the economy.