Explain the concept of excess demand in macroeconomics. Also explain the role of open market operation in correcting it.
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. Where, ${{AD}{FE}}$ = AD at full employment
${{AD}{AE}}$ = AD 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 ${{AD}_{AE}}$, 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 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 econdmy attains equilibrium.