question_answer

In an economy, aggregate demand is less than aggregate supply. Is the economy equilibrium? If not, explain the changes that will bring the economy in equilibrium. Income/Output Diagram Showing Deficient Demand (AD<As)

Answer:

If Aggregate Demand (AD) is less than Aggregate Supply (AS), then economy is not in equilibrium                         because an economy is in equilibrium when AS = AD. When AD < AS, flow of goods and services in the flow of goods and service in economy tends to exceed their demand. As a result, some of the goods would remain unsold.                        To clear unwanted stocks, the producers would plan a cut in production. Consequently, AS would reduce to become equal to AD. This is how AS adapts itself to AD. In the above figure, equilibrium is struck at point E where, AD = AS. At point Aggregate Supply exceeds Aggregate Demand (AS > AD), It will cause following changes in the economy:                                                (i) Stocks of the producers would be in excess of the desired limit,                                (ii) Desired level of output for the subsequent year will face a cut and profits will start shrinking.      (iii) Levels of income and employment will tend to shrink to the point where, S = /, corresponding to point E in the diagram.                                                                            Thus, the economy will come back to the state of equilibrium.