Question

Explain how equilibrium level of income can be determined with the help of aggregate demand curve and aggregate supply curve.

Answer 1

The equilibrium level of income in an economy can be determined through the interaction of the aggregate demand (AD) curve and the aggregate supply (AS) curve as follows:

• Aggregate Demand (AD) represents the total planned expenditure in the economy, consisting mainly of consumption expenditure by households and planned investment expenditure by firms. The AD curve (denoted as (C + I)) is derived by vertically summing the consumption function (C) (which increases with income) and autonomous investment (I) (which is constant, independent of income).
• Aggregate Supply (AS) refers to the total output produced in the economy, equal to the national income. It is represented by the 45-degree line emanating from the origin, where the value of output equals income.
• The equilibrium level of income occurs at the point where the aggregate demand curve intersects the 45-degree aggregate supply line. At this point (equilibrium), the desired aggregate expenditure equals the total output produced, implying:
   Aggregate Demand = Aggregate Supply → C + I = Y = C + S
• If income exceeds the equilibrium level, planned expenditure falls short of output. This generates unintended inventory accumulation, causing firms to reduce production and income.
• Conversely, if income is below equilibrium, planned expenditure exceeds output, leading to inventory depletion and encouraging firms to increase production and income.