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Question
Answer in detail.
Explain the equilibrium between Aggregate Demand and Aggregate Supply.
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Solution
The equilibrium level of income is determined at that point, where Aggregate Demand (AD) is equal to Aggregate Supply (AS). Here, AD refers to the planned/desired level of expenditure in the economy during an accounting year. Similarly, AS refers to the planned/desired level of output in an economy during an accounting year.
In the diagram, the consumption curve is depicted by C and the investment curve is depicted by the horizontal straight line parallel to the output/income axis. Summing up the investment curve and consumption curve, we get the aggregate demand curve represented by AD = C + I. The aggregate supply curve is represented by the 45° line. Throughout this line, the planned expenditure is equal to the planned output. That is, AS = Y = expenditure. The implication of the 45° line is that, in case of any disequilibrium, AS will be adjusted in a way to equate AD in order to restore equilibrium back. In other words, in case of any inequality between AD and AS, equilibrium output will be determined by AD.
The point E is the equilibrium point, where the planned level of expenditure (AD) is equal to the planned level of output (AS). In other words, this suggests that there is no undesired inventory accumulation. The equilibrium level of output is OQ, which is also known as the 'effective demand'.
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