Question

With the help of a diagram, determine the equilibrium level of output and income by using Aggregate demand and aggregate supply approach.

Answer 1

Equilibrium income refers to the level of real income or the level of output for which aggregate demand and aggregate supply become equal. Therefore, the equilibrium condition is stated as, AS = AD, i.e., Y = C + I.

Y_e is the equilibrium income because, for this level of income, the equilibrium condition Y = C + I has been satisfied. At Y = Y₁, C + I > Y, i.e., a situation of excess demand, which induces the producers to produce more and this leads to a rise in Y until Y = C + I, i.e., Equilibrium is restored.

Again, at Y = Y₂, C + I < Y, i.e., a situation of excess supply, which induces the producers to reduce the current production and this leads to a fall in Y until Y = C + I, i.e., Equilibrium is restored.