Question

Explain and illustrate diagrammatically the concept of excess demand.

Answer 1

The most important contention of Keynesian economics is that it is not necessary that the equilibrium level of income in an economy is attained at the level of full employment. The equilibrium level of national income will be attained at full employment level only when aggregate spending is sufficiently large to purchase the full employment output. It will be seen from Fig. that OY_f measures full employment output level. Since the aggregate demand represented by AD₀ is equal to the full employment level of output, the economy is in equilibrium at full employment. The intersection of AD₀ curve with 45° line at E gives us equilibrium corresponding to full employment level of output Y_f.

Now, suppose aggregate demand curve shifts upward to AD₁ due to, say, increase in government expenditure. The output will not increase since the economy is already at full employment level of output. Therefore, there will emerge excess demand in the economy. In Fig., a rise in government expenditure has created an excess demand equal to AD.

The amount by which the actual aggregate demand exceeds the aggregate output corresponding to full employment level in the economy, is known as excess demand.