Question

Discuss the adjustment mechanism in the following situation :
Aggregate demand is lesser than Aggregate Supply.

Answer 1

Aggregate demand is lesser than Aggregate Supply:

In case, if AS > AD, then it implies a situation, where the total supply of goods and services is more than the total demand for goods and services. This implies a situation of deficit demand. Due to the deficit demand, the producers experience piling-up of stock of unsold goods, i.e. inventory accumulation. This would force the producers to cut-back the production, thereby results in the reduced employment of factors of production. This leads to a fall in income and output. Finally, the income and output will fall sufficiently to equate the AD with AS, thus the equilibrium is restored back. This process of adjustment mechanism is explained below graphically.

In the figure, AD and AS represent the aggregate demand and aggregate supply curves. Let us suppose that the equilibrium is operating at a situation, where aggregate supply exceeds aggregate demand, i.e. AS > AD. TY´ represents the aggregate supply of output in the economy but the aggregate demand is only NY´. Hence, the economy is facing deficit demand or excess supply equivalent to TN (i.e. TY´ – NY´). Due to the excess supply, the producers experience stock of unsold inventories. Consequently, they cut-back their production and reduce employment. This results in a fall in production and employment. The income, output, and employment will continue to fall until all the excess supply is wiped-out. This happens at equilibrium point E, where AD and AS intersect each other. At the equilibrium, OY represents the equilibrium level of output and income.