Excess Demand-The situation in an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full employment, is termed as Excess Demand situation. In other words, the level of Aggregate Demand exceeds the level of Aggregate Supply even when there is full capacity production in the economy.
Here, ADFE = AD at full employment
ADAE = AD at above full employment
EF = Excess demand
In the above figure, E is the point where AD = AS. i.e. equilibrium point. But at the current, Excess Demand of ADAF Aggregate Demand FP is more than the Aggregate Supply of EP. 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 OP1.
Role of Open Market Operations in Correcting Excess Demand: Open market operations refers 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.
