When aggregate demand is less than aggregate supply at full employment level, there is deficient demand in the economy.
Repo rate is the rate at which central bank (RBI) gives loans to commercial banks. To correct the situation of deficient demand RBI will reduce repo rate. Banks in turn will reduce lending rate of interest, so there will be more demand for loans. This will increase money supply and correct the situation of deficient demand.
Detailed Answer:
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.
In the above figure, E is the equilibrium point of the economy where AD = AS. But at the present Aggregate Demand ADIU gives AB equal to FP which is less than the Aggregate supply of EP. Hence, EF represents the deficient demand in the economy.
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 falls. 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 Bank and also reduces the market rate of interest which encourages people to borrow more. In this way, the AD increases to the level of AS and the economy attains equilibrium.
