What are the measures to correct situation of excess demand/inflationary gap.
or
What is fiscal policy? How is it used to reduce excess demand? Discuss its three measures.
or 
Explain the role of government expenditure and taxation in reducing excess demand. 
or
What is monetary policy? How is it used to reduce excess demand? Discuss its measures. 
or
What is bank rate? Explain its role in reducing excess demand.
or
How do changes in bank rate affect money creation by commercial banks? Explain. 
or
What are open market operations? How do these affect availability of credit?
or
How do changing cash reserve ratio (CRR) affect availability of credit?
or
Explain role of 'varying reserve requirement' in removing inflationary gap.
or
Explain role of 'legal reserves' in correcting inflationary gap. 

Measures to control situation of excess demand

Keeping in view the adverse effects as stated above, aggregate demand has to be reduced by an amount equal to inflationary gap. Here we include Government sector which affects the economic activity through its expenditure and tax programme. This inclusion of government sector means that aggregate demand is now equal to sum of consumption, investment and Government expenditure, i.e., AD = C + I + G. The three most important measures to control excess demand are fiscal policy, monetary policy and foreign trade policy. Fiscal policy is used by the government whereas monetary policy is used by Central Bank of the country. However, the following measures are suggested to rectify the situation of excess demand.

1. Fiscal Policy. Fiscal policy is the expenditure and revenue (tax) policy of the government to accomplish the desired objectives. In case of excess demand (i.e., when current demand is more than AS at full employment), objective of fiscal policy is to reduce aggregate demand. Main tools of fiscal policy are:

(i) Expenditure policy (Reduce expenditure). In a situation like that of excess demand, government should curtail its expenditure on public works such as roads, buildings, rural electrification, irrigation works thereby reducing the money income of the people and their demand for goods and services. In this way, government should reduce the budget deficit which shows excess of expenditure over revenue. When government expenditure increases, AD of an economy increases by the same amount.

(ii) Revenue policy (Increase taxes). The other important part of fiscal policy is revenue policy which is expressed in terms of taxes. During inflation, government should raise rates of all taxes especially on rich people because taxation withdraws purchasing power from the tax payers and to that extent reduces effective demand. Care should be taken that measures adopted to raise revenue should be disinflationary and at the same time have no harmful effects on production and savings.

Here distinction is made between discretionary and non-discretionary measures used by the government. The non-discretionary elements refer to inbuilt stabilizers of income which operate automatically. Progressive income-tax, grants, subsidies, old age pension and other such like transfer payments are non-discretionary measures which operate automatically in both the situations of excess demand and deficient demand. As against it, discretionary measures refer to reduction in expenditure on public works, on public health and education, on defence and internal administration, etc.

(iii)    Public borrowing (Increases it). Additionally, government should resort to large scale public borrowing to mop up excess money with the public.

(iv)    Deficit financing (Reduce it). At the same time deficit financing (Printing of currency-notes) should be cut down drastically. Reducing deficit financing will reduce government ability to spend which, in turn, will decrease AD in the economy. Deficit financing is a method adopted by the government for financing its deficit through printing of more currency-notes.

2. Monetary Policy (Raise bank rate and cash reserve ratio). Monetary policy is the policy of the central bank of a country to regulate and control money supply and credit in the economy. Money broadly refers to currency-notes and coins whereas credit refers to loans. Monetary measures (instruments) affect the cost of credit (i.e., rate of interest) and availability of credit. Thus it helps in checking excess demand when credit availability is restricted and credit is made costlier. Measures of monetary policy may be (a) quantitative (which influences volume of credit indiscriminately), and (b) qualitative (which regulates flow of credit for specific uses).

(I) Quantitative Measures.

(i) Bank rate (Increase bank rate). Bank rate is the rate of interest at which Central Bank lends to commercial banks. Changing bank rate to influence credit availability is called Bank Rate Policy. Mind, Central Bank lends to only commercial banks and not to general public. In a situation of excess demand leading to inflation, Central Bank raises bank rate. This raises cost of borrowing which discourages commercial banks in borrowing from Central Bank. Increase in bank rate forces the commercial banks to increase their lending rate of interest to consumers and investors. Thus makes credit costlier. As a result, demand for loans falls. Again high rate of interest slows down the demand for goods and services and induces households to increase their savings by restricting expenditure on consumption and discourages investment. Thus expenditure on investment and consumption is reduced and this reduces credit creation by commercial banks. Remember rate of interest represents cost of money. Presently (February, 2012) bank rate or repo rate (rate at which banks borrow from RBI) is 8.5% and Reverse repo rate (rate at which banks park their surplus funds with RBI) is 7.5%.

(ii) Open Market Operation (Sell securities). It refers to buying and selling of government securities and bonds in the open market by the Central Bank. This is done to influence the volume of cash reserves with the commercial banks. Sale by Central Bank brings flow of money to Central Bank from commercial banks thereby restricting their lending capacity. Such operations affect amount of cash reserves with the commercial banks and their capacity to offer loans. During inflation, Central Bank sells government securities to commercial banks which lose equivalent amount of cash reserve thereby affecting their capacity to offer loans. This absorbs liquidity from the system. As a result, there is fall in investment and aggregate demand. Thus it is an effective measure to control credit.

(iii) Cash Reserve Ratio (Raise CRR) (D 2011). It is ratio (or fraction) of bank deposits that a commercial bank must keep as reserve with the Central Bank. Every commercial bank is required under law to keep with central bank a minimum percentage (say, 8 per cent) of its deposits or reserve in the form of cash. This is called Cash Reserve Ratio. The bank is free to lend the remaining deposits. Higher the CRR, lessei is bank's lending capacity. When there is an inflationary situation, Central Bank raises the rate of minimum cash reserve ratio thereby curtailing the lending capacity of commercial banks. The RBI fixes rates of CRR according to market conditions. At present CRR is 5.5% w.e.f. 28th January 2012.

Statutory Liquidity Ratio (SLR). In addition to CRR, there is another measure called SLR according to which every bank is required to hold a minimum proportion of its total demand and time deposits in the form of liquid assests (e.g. government securities) as per regulation of RBI. When RBI wants to contract credit or lending by banks, it raises SLR and thereby reduces credit availability.

Legal Reserve Ratio (LRR). It is the minimum ratio of demand deposits fixed by RBI which is legally compulsory for every commercial bank to keep as cash reserves. It has two components – CRR and SLR as explained above.

(II) Qualitative Measures (The control purpose and direction of credit).

(iv) Moral Suasion (Restrict credit). This refers to written or oral advice given by Central Bank to commercial banks to restrict or expand credit.It is a combination of persuation and pressure which is exercised through letters, discussion and speeches. During inflation, the Central Bank of a country employs selective credit control measures like moral suasion. For instance, it persuades its member banks not to advance credit for speculation or prohibits banks from entering into certain transactions. This advice is generally followed by member banks.

(v) Margin Requirements (Increase it). Margin requirements refer to the amount of security that banks demand from borrower of loan. It is the difference between the amount of loan granted and the current value of security offered for taking loan. In a situation of excess demand, Central Bank raises the limit of margin requirements. This discourages borrowing because it makes traders get less credit against their securities. On the other hand, in case of deficient demand, margin requirements are lowered to encourage borrowing.

Other anti-inflationary measures of monetary policy are credit rationing, control of consumer credit, wage freeze, compulsory saving scheme for households, etc.

3. Foreign Trade Policy (Enlarge import surplus). In a situation of excess demand, import surplus (excess of imports over exports) should be created and enlarged because imports act a leakage from income stream. Thus the excess demand will be reduced to the extent of import of goods produced by other countries. Hence, a liberal policy is very helpful. However, import surplus can be financed (i) by drawing upon foreign exchange reserve or gold reserves, (ii) by taking loans from foreign governments or World Bank, etc., and (iii) by taking aid from other countries in the form of grants.