When aggregate demand for goods and services exceeds aggregate supply of output which is produced by fully employment the given resources of an economy, excess demand is said to occur. This excess demand leads to the rise in general price level, that is, inflation in the economy. When aggregate demand exceeds aggregate supply at the current prices at full employment level, the demand inflation is, said to exist.
Excess demand results in inflation which is described as demand-pull inflation. At the full employment level, all the productive resources are fully exhausted. Any increase in demand can not bring about rise in real output. The real output remains constant whatever the demand may be.
Given the supply of output price level is pushed up with the increasing demand. This excess demand is statistically measured by inflationary gap. The inflationary gap can be removed by increasing output to the extent of increased expenditure. However Demand pull inflation can be eradicated by pursuit different measures. They are (i) fiscal measures (ii) monetary measures (iii) direct controls etc. (i) Fiscal Measures:
(1) Increase in taxation
Anti inflationary tax policy should be directed to restrict demand without restricting production. Sale tax and Excise duty take away the buying capacity without discouraging productive capacity of the economy. Progressive tax is highly preferred to reduce the disposable income of the people.
(2) Reduction in public expenditure
During inflation there is excess demand because of the expansion of public and private spending. So the Govt should reduce unproductive expenditure to the extent of expenditure over the national output. A reduction in public expenditure will lead to a multiple reduction in the total expenditure of the economy.
(3) Public borrowing:
Through public borrowing, the Govt takes away from public excess purchasing power. This will reduce aggregate demand and hence the price level. Generally public borrowing is voluntary; voluntary public borrowing may not fetch sufficient purchasing power to the Govt, so that inflationary pressure will be arrested. The fore Govt will resort to compulsory public borrowing. Through compulsory public borrowing part of the wage or salaries is compulsorily deducted which become redeemable after a few year.
(4) Control of deficit financing:
Financing, the deficit budget through printing of new notes is known as deficit financing. The Govt should minimize deficit financing. The deficit shoed is financed through saving or taxation. The Govt can sell bonds to non-bank investors, like insurance companies, and takes away the spending power from the public and hence inflation is curbed.
(5) Over valuation:
A over valuation of domestic currency in terms of foreign currencies will also serve as an anti-inflationary measure. Firstly it will discourage exports and thereby increase the availability of goods in the domestic market. Secondly by encouraging imports from abroad it will add to the domestic supply of goods in the economy. But over valuation as an anti inflationary weapon suffers from several limitations, (ii) Monetary measures:
(1) Increased Re-discount rates:
An increase in bank rate tends to discourage borrowing by business from banks; and thereby lessening the pressure of inflation in the economy. An increase in the interest rate due to increase in the bank rate will make savings attractive than before and induce people to spend less on consumer goods.
(2) Sale of Govt, security in the open market:
The central bank directly reduces the liquidity of the commercial banks by selling Govt, securities in the open market. The fall in cash reserves does not allow the commercial banks to expand their lending capacities. This will reduce the money supply and hence the inflationary pressures in the economy.
(3) Higher reserve ratio:
An, increase in the minimum reserve ratio will help in curbing inflationary pressure in the economy. The member banks are required to keep larger reserves with the central bank. This reduces the deposits of the banks and thus limits their power to create credit. Inflationary pressure can be controlled by restricting the creation of credit by the commercial banks.
(4) Selective Credit-Control:-
Under selective credit control certain types of credits are restricted while other types of credit remain unaffected. This method is highly beneficial for developing countries. In such a situation the flow of credit is directed to the productive and growth oriented sectors from unproductive sectors.
(5) Consumer Credit Control:-
This method is adopted to curb excess demand expenditure. In developed countries luxurious censurer durables are purchased on hire and installment basis. During inflation, consumer durable loan facilities for installment buying are reduced and restricted. This helps in reducing consumption spending.
(6) Higher margin requirements:-
Margin requirement is the difference between the market value of the security and its maximum loan value. During inflation, the margin requirement can be raised to reduce the loan.