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Aggregate Demand-Aggregate Supply (AD-AS) Approach

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Aggregate demand (AD) is the total amount of final products and services that all sectors of the economy intend to purchase over a single accounting year at a specific level of income. Whereas, Aggregate Supply (AS) refers to the monetary value of finished goods and services that all producers are prepared to supply to an economy over a specific time frame. The Aggregate Demand-Aggregate Supply Approach (AD-AS Approach) is used to determine the equilibrium level of income, output, and employment in an economy.

Determination of Equilibrium Level 

The Keynesian Theory states that the equilibrium situation is usually expressed in terms of Aggregate Demand (AD) and Aggregate Supply (AS). When aggregate demand for products and services over a given period of time equals aggregate supply, an economy is in equilibrium.

So, equilibrium is attained when:

AD = AS 

Assumptions

The various assumptions used to determine equilibrium output are:

  1. The determination of the equilibrium level will be examined using a two-sector model (households and firms). Simply put, it is assumed that there is no foreign industry or government in the economy.
  2. It is also assumed that investment expenditure is autonomous, i.e., that income level does not have any impact on investments.
  3. It is assumed that the pricing level is constant.
  4. Also, to determine equilibrium output, short-run will be considered.

Aggregate Demand-Aggregate Supply Approach (AD-AS Approach)

The Keynesian theory states that when aggregate demand, as shown by the C+I curve is equal to the total output (Aggregate Supply or AS), the equilibrium level of income in an economy is established. 

There are two parts to the aggregate demand:

  • Consumption Expenditure (C): This expenditure changes directly with income; i.e., consumption rises as income rises.
  • Investment Expenditure (I): This expenditure is considered to be autonomous and independent of one’s income level.

So, in the income determination analysis, the AD curve is represented by the C+I curve. 

The overall output of goods and services from the national income is known as the aggregate supply. A 45° line is used to represent it. The AS curve is represented by the (C+S) curve because the money received is either spent or saved.

Example:

Equilibrium by AD and AS Approach

 

 

AD-AS Approach

 

The AD or (C+ I) curve in the above graph shows the desired expenditure level by consumers and businesses at each level of income. At point E where the (C+ I) curve intersects the 45° line, the economy is in equilibrium.

Observations:

  • The equilibrium point, denoted by the letter E, occurs when desired expenditure on consumption and investment is equal to the total output.
  • OY is the output at the equilibrium level that corresponds to point E.
  • In the above table, the Aggregate Demand is equal to the Aggregate Supply; i.e., ₹200 Crores, when the equilibrium level of income is ₹200 Crores.
  • It is a case of Effective Demand. Effective demand refers to that level of AD that becomes ‘effective’ since it is equal to AS.

Readjustment Process

When there is any deviation from the equilibrium level of output; i.e., if the planned spending or AD is not equal to planned output or AS, then to bring them equal to each other, the process of readjustment is started in the economy.

1. When AD is more than AS

If planned expenditure (AD) exceed planned output (AS), the (C+ I) curve will be over the 45° line. In this situation, consumers and businesses together would be purchasing more items than they are willing to produce, because of which the planned inventory would ultimately fall below the desired level. Therefore, until the economy reaches output level OY, where AD equals AS and there is no longer a tendency to fluctuate, firms would increase employment and output to bring the inventory back to the desired level.

Planned Inventory refers to the unsold inventory that has been anticipated in the event of an expected decline in sales; whereas, Unplanned Inventory refers to the unanticipated change in stock as a result of an unexpected decline in sales.

2. When AD is less than AS

If planned expenditure (AD) is less than planned output (AS), (C+ I) curve will lie below the 45° line. In this situation, consumers and businesses together would be purchasing fewer items than they are willing to produce, because of which the planned inventory would rise. Therefore, until the economy reaches output level OY, where AD equals AS and there is no longer a tendency to fluctuate, firms would decrease employment and output to bring unwanted inventory back to the desired level.


Last Updated : 22 Mar, 2023
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