Explain the concept of excess demand. How can government spending policy be helpful in correcting the situation of excess demand ?

Question

Accepted Answer

**Excess Demand** refers to the situation when aggregate demand exceeds aggregate supply at the full employment level of output. Since the economy is already at full employment, this excess demand cannot be met with increased production and only leads to rise in general price level (inflation).

**Government spending policy to correct excess demand:**
- **Reduction in Government Spending:** Government can cut its expenditure on non-essential items, reducing aggregate demand directly
- **Reduction in Transfer Payments:** Lowering subsidies and welfare payments reduces disposable income of households, lowering consumption
- **Postponement of Public Projects:** Delaying non-essential infrastructure projects reduces government expenditure
- The reduction in government spending has a multiplier effect, leading to a larger reduction in national income and aggregate demand