Question

Explain with the help of appropriate diagram, the determination of equilibrium level of income and output, using the aggregate demand and aggregate supply approach. Is this equilibrium level of income full employment level?

The equilibrium level of income is determined by the intersection of the aggregate expenditure curve and the 45° degree line. Explain with the help of a diagram.

Answer 1

In the aggregate demand – aggregate supply (AD – AS) approach, the equilibrium level of income is where aggregate demand equals aggregate supply. Aggregate demand includes planned consumption by households and planned investment by firms. Consumption (C) is shown as an upward-sloping line, reflecting a positive relationship with income. Investment (I) is autonomous and shown as a horizontal line (II), independent of income. The aggregate demand curve (C + I) is formed by vertically adding the C and I curves, making it parallel to the C curve with a constant gap equal to the level of investment.

Aggregate supply means the total value of all goods and services produced in a country in one year. It is the same as national income or national output. In diagrams, it is shown by a 45° line from the origin. This line represents situations where income equals output, so the value of what is produced is the same as the income earned. At any point on the 45° line, the vertical distance from the X-axis is equal to the level of income shown on the horizontal axis. So, income can be measured both horizontally and vertically.

In a two-sector economy (with only households and firms), the total income is used in two ways:

• Part is spent on consumption
• The rest is saved

Thus, AS = Y = C + S

In the diagram, income is on the X-axis, and consumption (C) and investment (I) are on the Y-axis. The C + I curve shows aggregate demand, and the 45° line represents aggregate supply (AS).

The equilibrium level of income is at point E, where aggregate demand equals aggregate supply. At this point (Y₀), planned spending matches total output, so firms sell all they produce and have no reason to change output. Thus, income and output are in equilibrium.

The economy is at equilibrium when aggregate demand equals aggregate supply, i.e., at income level Y₀.

• If output is greater than Y₀ (e.g., at Y₁), aggregate demand is less than output by AB. This leads to unsold inventories, forcing firms to reduce production, causing income to fall back toward Y₀.
• If output is less than Y₀ (e.g., at Y₂), aggregate demand exceeds output by GH. Firms meet extra demand by using up inventories. As inventories fall, firms increase production, and income rises to Y₀.

Thus, due to unplanned changes in inventories, the economy automatically moves toward the equilibrium income level Y₀, where planned spending = total output, and there is no tendency to change production.

Aggregate Demand = Aggregate Supply

C + I = C + S