Excess Demand: Meaning, Inflationary Gap, Reasons and Impacts (with diagram)

Meaning:

When in an economy, aggregate demand is in excess of ‘aggregate supply at full employment’, the demand is called an excess demand. Alternatively when aggregate demand exceeds ‘aggregate supply at full employment level the demand is said to be an excess demand and the gap is called inflationary gap. The gap is called inflationary because it causes inflation (continuous rise in prices) in the economy.

Inflationary Gap:

When aggregate demand is more than ‘level of output at full employment’, then the excess or gap is called inflationary gap. Alternatively ‘it is the amount by which actual aggregate demand exceeds the level of aggregate demand required to establish the full employment equilibrium.’ Thus, inflationary gap is a measure of the amount of excess of aggregate demand over ‘aggregate supply at full employment’.

In such a situation, an increase in demand means only an increase in money expenditure without any corresponding increases in output and employment because all the resources have already been fully employed.

Let us suppose that an imaginary economy by employing all its available resources can produce 10,000 qtls of rice. If aggregate demand for rice is, say, 12,000 qtls., this demand will be called an excess demand because aggregate supply at the level of full employment of resources is only 10,000 qtls. As a result, the excess of 2,000 qtls will be called an inflationary gap.

This situation is depicted in Fig. 8.16. Here, point E lying on 45° line is the full employment equilibrium point. This is an ideal situation because aggregate demand represented by EM is equal to full employment level of output (aggregate supply) represented by OM.

Suppose, the actual aggregate demand is for a level of output BM which is greater than full employment level of output EM (OM). The difference between the two is EB (BM – EM) which is a measure of inflationary gap or excess demand.

In short, the inflationary gap is the amount by which the actual aggregate demand exceeds the aggregate demand required to establish full Output and Income employment equilibrium.

Reasons:

The main reasons for excess demand are apparently the increase in four components of aggregate demand (see Section 8.4). For instance, there may be (i) increase in household consumption demand due to rise in propensity to consume; (ii) increase in private investment demand because of rise in credit facilities; (iii) increase in public (government) expenditure; (iv) increase in export demand and (v) increase in money supply (deficit financing) or increase in disposable income (due to fall in rate of taxes).

Impact of Excess Demand:

Briefly, it causes rise in prices and increases in equalities:

Generally, excess demand results in inflation (continuous rise in prices) without increase in output and employment. But in different situations in the economy, the impact will also be different. We discuss the impact of excess demand in reference to these situations, namely, (i) Whether, the economy is in a state of unemployment or full employment, (ii) Whether the supply of factors of production is elastic or inelastic.

Thus, following will be the impact of excess demand on prices, employment and output:

(i) If it is a state of voluntary unemployment and unemployed factors become ready to work, a rise in demand will lead to an increase in output and employment, i.e., voluntary unemployment will be lessened. Increase in demand helps the output and employment to increase without an increase in prices so long as there are unemployed and under-employed resources.

(ii) If it is a state of full employment, i.e., involuntary unemployment does not exist, excess demand results in inflation or general rise in price level. Employment will not increase because there is no involuntary unemployment.

Output will also not increase since all the available resources are already being used fully. Of course, there can be a possibility of increase in output only if productivity of labour is increased in the long period. But in short period, when it is not possible to increase productivity of labour, an inflationary situation may develop due to rise in prices.

(iii) As far as impact on prices is concerned, if supply of other complementary factors is elastic, prices will not be affected much due to matching adjustment in output and emplo3mient. But if supply of factors is inelastic, prices will rise since output cannot be increased appreciably.

We may conclude that increase in demand beyond the level of full employment does not lead to an Increase in output and employment. Without increase in total output (supply), excess demand ultimately consumes itself into price rise, i.e., degenerates into inflation with adverse effects on saving, production and distribution.

It is because of this phenomenon that sometimes it is said that increase in aggregate demand beyond the level of full employment leads to an increase not in real income (in terms of goods and services) but in money income.

Causes of Excess Demand:

These are:

(i) Deficit financing (printing of currency notes),

(ii) Increase in Marginal Propensity to consume and

(iii) Increase in autonomous investment. 

Deflationary Gap:

Deflationary gap is the amount by which actual aggregate demand falls short of aggregate supply at level of full employment’. For instance, in Fig. 8.17, EB is shown as deflationary gap. It is a measure of amount of deficiency of aggregate demand. Deflationary gap causes a decline in output, income and employment along with persistent fall in prices.

Deflationary gap and equilibrium level of income:

Remember, equilibrium level of income indicates mere equality between aggregate demand and aggregate supply regardless of whether the equilibrium is at full employment or under-employment of resources.

In case, it is full employment equilibrium where all resources are employed to their full limit, deflationary gap cannot exist at equilibrium level of income. But if it is an under-employment equilibrium where all resources are not fully employed, i.e., some resources are under­employed, then deflationary gap can exist at the equilibrium level of income.

Cost-Push Inflation and Demand-Pull or Mixed Inflation

Dichotomy in inflation theory; demand-pull and cost-push, is now a part of the language of economics, some economists object to its implication that an inflation is either demand-pull or cost- push.They argue that any actual inflationary process contains some elements of both. Expressed in this fashion their argument can hardly be denied. 

However, if the dichotomy is accepted as nothing more than a convenient two-fold classification of types of causation, their objections do not apply; it is at least helpful in separating two distinct sets of forces that are usually simultaneously and interdependently at work in any actual inflationary process.

In terms of this dichotomy, it should be noted that there is a lack of symmetry between the demand-pull and cost-push theories. An inflationary process may begin with generalized excess demand and may be expected to persist as long as excess demand is present, even though no cost-push forces whatsoever are at work.

Excess demand will raise prices, which in turn will raise wage rates, but the rise in wage rates in this case is not the result of cost-push. We notice, however, that this does not rule out the possibility that cost-push forces may also be at work to produce an even greater rise in wage rates.

On the other hand, an inflationary process may begin on the supply side but it will not long persist unless there is an increase in demand. For example, an autonomous rise in wage rates will raise prices in the absence of any increase in demand. For a cost-push inflation so initiated to be sustained however, one wage increase must be piled on top of another; but in the absence of an increase in demand this would mean ever smaller production and ever greater unemployment. Sooner or later this must limit any inflationary process that depends on changes on the supply side alone. This asymmetry can be illustrated by Fig. 32.10.

With output at Y_f, shifts in the aggregate demand function from AD₁ to AD₂ to AD₃ and beyond can carry the price level ever higher, from A to E to G, and so forth, in a sustained inflationary process. With full employment, wage rates will rise along with prices as producers, encouraged to expand output by the enlarged profits that result from the rising aggregated demand, increase their demand for labour. As long as the forces feeding the demand for final output continue to shift the AD function ever higher, inflation will continue unchecked.

In the extreme case, a run-away price level known as ‘hyper-inflation” may result. However, starting again from Y_t a wage push or a profit push that shifts the aggregate supply function from AS₁ to AS₂ will, with the AD function still at AD₁, produce an intersection at B and reduce output below the full employment level. A further upward push on the supply side to AS₃, unless accompanied by a shift in AD above AD₁, will move the intersection to ‘C’ and further reduce output and employment.

The successive reductions in output and the growing unemployment that result under these conditions will bring the inflation to an end. Thus, unlike demand pull, inflation may originate on the supply side but it cannot be sustained unless there is an appropriate increase on the demand side.

Demand-Pull Versus Cost-Push Inflation :

No single explanation will suffice when we deal with a phenomenon as complicated as inflation in the modern economy. Some economists object that inflation is either demand-pull or cost-push and feel that the actual inflationary process contains some elements of both. These theories should not be taken as alternatives in any absolute sense but as approaches that lay stress on one factor relatively more than the other. In practice, it is very difficult to establish by empirical tests whether inflation is demand-pull or cost-push.

Pure demand-pull or a pure cost-push inflation is rarely found. It is true that modern economic analysis no longer sees the problem of inflation as basically a matter of too much money in circulation, but this does not mean that money supply is not important. Barring unprecedented shifts in the velocity of circulation of money (V), all the theories of inflation predicate increases in the money supply. H. Johnson, therefore, remarks, “The two theories are not independent and self-contained theories of inflation, but rather theories concerning the mechanism of inflation in a monetary environment that permits it.”

Fritz Machlup in one of his recent papers has presented another view of cost-push and demand- pull inflation. According to Machlup, inflation may be defined as a rising price level, yet it needs considerable expansion and clarification before it can really be considered meaningful. He deals with the contention that the distinction between cost-push and demand-pull inflation is unworkable, irrelevant, or even meaningless. There is a group of outstanding economists who contend that there cannot be such a thing as a cost-push inflation because, without an increase in the purchasing power and demand, cost increases would lead to unemployment and depression, not to inflation.

Similarly, there are assumptions for which it would be appropriate to say that demand-pull is no cause of inflation—it takes cost-push to produce it. In other words, the contention must be granted that there are conditions under which ‘effective demand’ is not effective and won’t pull up prices, and when it takes a cost- push to produce price inflation.

But this position ignores an important distinction, namely, whether the cost-push is ‘equilibrating’ in the sense that it ‘absorbs’ a previously existing excess demand or whether it is ‘dis-equilibrating’ in the sense that it creates an excess supply (of labour and productive capacity) that will have to be prevented or removed by an increase in effective demand.

Fritz Machlup identifies the limitations of the conventional approach to inflation and develops a more adequate framework in terms of the concept of autonomous, induced, and supportive demand inflation and aggressive, defensive, and responsive cost inflation. On the basis of these concepts, he has developed model sequences of the inflationary process and applied them briefly to what may be the most perplexing problem in the study of inflation—identifying whether any concrete inflationary experience was ‘initiated’ by cost-push or demand-pull forces.

The Structural Hypothesis:

Apart from the controversy about the demand-pull and cost-push theories of inflation in the USA, Prof. Charles Schultze put forward an alternative theory of inflation called structural inflation hypothesis or sectoral demand shift inflation theory. This theory was used to explain the American inflation of the 1950s through 1960s, 1970s, and the 1980s. It shows that inflation may be the consequence of internal changes in the structure of demand, even though overall demand may not be excessive.

This theory of inflation is based on the fact that in many areas and sectors of the economy wages and prices are flexible upward in response to increases in demand, but not flexible downward when demand declines. In other words, this theory emphasizes the fact that inflationary pressure can be generated by internal changes in the composition of demand alone. In a dynamic economy such changes are an essential part of the economic process, consequent upon changes in the structure of consumer tastes and desires. 

The expansion of demand for the output of particular industries or sectors will lead to wage and price increases in these areas or sectors because wages and prices have an upward sensitivity when demand is rising. But the contraction of demand in other sectors will not lead to any corresponding downward movement of prices. Thus, overall, the average level of price will surely rise. The structural inflation thesis makes prices inflation inherent in the process of resource allocation, if wages and price are flexible upward but not downward. The structural inflation differs from demand-pull and cost-push inflations in that it stresses changes in the composition of demand.

In this type of analysis the starting point for inflation is a change in the structure and composition of demand, which means a rise in demand for the products of particular industries—this is a common feature in a dynamic economy. As a result, wages and prices rise upward in response to shifts in demand of certain sectors but do not fall in those sectors where there is a relative decline in demand. Not only prices and wages fail to fall in the industries where demand declines, they may actually rise.

The increase in wages and prices in industries and sectors with rising demand will force the demand deficient industries and sectors to pay higher wages and prices for labour and materials to continue their production. Thus, wage price increases in particular areas gradually spread out and permeate the whole economy.

The most important implication of the structural explanation of inflation is that ordinary monetary and fiscal measures of general character are not capable of coping with this type of inflationary situation. They may control the aggregate demand but not the structure or composition of demand which calls for different selective measures. However, the position has been well summed up by James Tobin’—who says that the nature of current global inflation specially of USA is complex, difficult to diagnose and unique in modern history.

In general we may distinguish three types of inflation:

(a) Excess demand inflation—“too much money chasing too few goods”;

(b) The wage—price—wage spiral and

(c) Shortages and price increases, in important ‘commodities’.

To this may be added another variety of imported inflation: as a result of unprecedented hike in oil prices by the OPEC Cartal after 1973 affecting the domestic prices of developed and developing economies particularly. According to Tobin our current inflation is a combination of (b) and (c) above but monetarists ignore all types of distinctions and consider current inflation due to (a) above.

Conclusion:

We may conclude our discussion in this way Equilibrium level of national income is determined by the equality between aggregate demand and aggregate supply (or between savings and investment). An ideal situation for an economy is full employment equilibrium, i.e., when its aggregate demand and aggregate supply are in equilibrium at such a point where all the resources of the economy are fully employed. Every economy aspires for it.

But in real world situation, aggregate demand either exceeds or falls short of the level of full employment supply. Excess demand results in inflation without an increase in output and employment whereas deficient demand leads to unemployment and fall in output, income and prices.

Both the situations bring harmful effects on the economy and, therefore, require to be checked by adopting fiscal, monetary and other measures. All these measures should be integrated and used as complementary to each other, rather counter to each other. Therefore, all efforts should be made to achieve and stay at the equilibrium level of income ensuring full employment of all the available resources.