Question

What happens to output, income employment and price level when there is excess demand?

Explain with the help of a diagram the situation of excess demand in an economy.

Explain and illustrate diagrammatically the concept of excess demand.

Answer 1

The main point of Keynesian economics is that the equilibrium level of income in an economy does not have to be obtained at full employment. Only when aggregate spending is sufficient to purchase full employment production will the equilibrium level of national income be reached. Figure shows that OY_f measures the full-employment output level. Because AD₀ represents aggregate demand equal to full employment output, the economy is in equilibrium at full employment. The intersection of the AD₀ curve with the 45° line at E yields equilibrium, which corresponds to the full employment level of output Y_f.

Assume the aggregate demand curve changes upward to AD₁ due to, say, an increase in government spending. The economy is already at full employment; thus, output will not expand. As a result, the economy will experience excessive demand. In Figure, an increase in government spending has resulted in an excess demand equal to AD.