Question

Discuss the working of the adjustment mechanism in the following situations:

Aggregate demand is greater than the aggregate supply.

Discuss the working of the adjustment mechanism in the following situations:

If Aggregate demand is greater than the aggregate supply.

Answer 1

When Aggregate Demand is greater than Aggregate Supply
In case AD > AS, then it implies a situation where the total demand for goods and services is more than the total supply of goods and services. This implies a situation of excess demand. Due to the excess demand, the producers draw down their inventory and increase production. The increase in production requires hiring more factors of production, thereby increasing the employment level and income. Finally, the income will rise sufficiently to equate the AD with AS, thus the equilibrium is restored. 
This process of the 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 demand exceeds aggregate supply, i.e., AD > AS. TY’ represents the aggregate demand of output by the economy, but the aggregate supply is only of NY'.Hence, the economy is facing excess demand equivalent to TN (i.e. TY’ – NY’). Due to the excess demand, the producers draw down their inventories and hire more factors of production. This results in an increase in production and employment. The income, output, and employment will continue to rise until all the excess demand is wiped out. This happens at the equilibrium point E, where AD and AS intersect each other. At the equilibrium, OY represents the equilibrium level of output.

Answer 2

When Aggregate Demand is greater than Aggregate Supply (AD < AS), buyers are planning to buy more goods and services than what producers are planning to produce. It will lead toa fall in planned inventories above the desired level. The producers, in turn, will produce more, which will increase the income level, i.e., AS. This process will continue till AD becomes equal to AS.