Explain the concept of excess demand; also explain the role of repo rate in reducing it.

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.