Excess demand refers to the excess of aggregate demand over the aggregate supply in an economy at full employment level. It can be explained with the following diagram:
● In the above figure, the X-axis shows the national income and the Y-axis shows the aggregate demand.
● O is the 45-degree line showing the aggregate supply side. AD is the aggregate demand curve.
● When the demand increases to AD’, the excess demand or the inflationary gap is shown by AB.
● This is because at full employment Y’, the aggregate demand BY’ is greater than the aggregate supply AY’.
● Reverse repo rate is the rate at which the central bank borrows money from the commercial banks.
● If there is excess demand, it leads to inflation.
● In such a situation the reverse repo rate is increased.
● This encourages the commercial bank to lend to the central bank as it will help them to earn a higher return on the idle cash.
● It reduces the lending capacity of commercial banks to consumers and investors.
● This helps to control the excess demand.
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