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Aggregate Demand, Aggregate Supply and Equilibrium Level of National Income

Updated: Nov 11, 2018

Theme 5: Introduction of Macroeconomics

Topic: Aggregate Demand, Aggregate Supply and Equilibrium Level of National Income

Relevance: H1 and H2 Economics

Introduction:

The equilibrium level of national income can be understood using the Aggregate Demand and Aggregate Supply (AD-AS) framework through the interactions between the different sectors of an economy.

  • Aggregate demand is defined as the total spending on goods and services produced within the economy at various general price level, over a given time period, ceteris paribus. Aggregate demand also represents the total planned spending in an economy which consists of the summation of consumer expenditure (C), investment (I), government expenditure (G) and net exports (X-M), AD = C+I+G+(X-M).

  • Aggregate supply is defined as the total output of goods and services produced within the economy at various general price level, over a given time period, ceteris paribus.

Equilibrium level of national income occurs when aggregate demand (AD) equals aggregate supply (AS) at PE and YE as shown in Figure 1, as there is no tendency for the either real national income or general price level to change.

Figure 1: Economy in Equlibrium

In the short run, the economy might be in disequilibrium when the current general price level is not the same as the equilibrium general price level (PE) as aggregate demand does not equate to aggregate supply.


If the current general price level (PH) is higher than the equilibrium general price level (PE) as shown in Figure 2. There will be an unplanned surplus of inventories or excess supply of goods and services produced in the economy as aggregate demand is less than aggregate supply. This will signal to firms to reduce production and prices to reduce the build-up of excess inventories. This will lead to a decrease the real national income and as the economy move closer to the equilibrium level of national income.

Figure 2: Unplanned Surplus of Inventories

If the current general price level (PL) is lower than the equilibrium general price level (PE) as shown in Figure 3. There will be an unplanned shortage of inventories or excess demand of goods and services produced in the economy as aggregate demand is higher than aggregate supply. This will signal to firms to increase production and prices to reduce the excess demand of goods and services. This will lead to an increase the real national income as the economy move closer to the equilibrium level of national income.

Figure 2: Unplanned Shortage of Inventories

The economy will be in equilibrium once again when aggregate demand (AD) equals to aggregate supply (AS) at PE and YE as shown in all figures and there will be no tendency for the either real national income or general price level to change unless the equilibrium is disturbed by changes in Aggregate Demand (AD) equals Aggregate Supply (AS).

Changes in Aggregate Demand and Aggregate Supply:

While increase in aggregate supply will lead to an unplanned surplus of inventories, however there will be net effect of an increase in the real national income.

On the other hand, while decrease in aggregate demand will also lead to a surplus, however there will be net effect of a decrease in the real national income.


While decrease in aggregate supply will lead to a unplanned shortage of inventories, however there will be net effect of an decrease in a decrease in the real national income.

On the other hand, while increase in aggregate demand will also lead to a unplanned shortage of inventories, however there will be net effect of an increase in the real national income.


Aggregate demand (AD) is affect by changes in any of its components; consumer expenditure (C), investment (I), government expenditure (G) and Net Exports (X-M)

Aggregate supply (AS) is affected by changes in unit cost of production, quality and quantity of factors of productions and state of technology.

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