Determining Equilibrium Income with AD-AS

1. The Condition for Equilibrium

In macroeconomics, the economy is said to be in equilibrium when the total planned spending on goods and services equals the total output of goods and services. In other words, equilibrium occurs when Aggregate Demand (AD) is equal to Aggregate Supply (AS).

Let's quickly define our terms in a simple two-sector economy (households and firms):

• Aggregate Supply (AS): This is the total value of all final goods and services produced in an economy. Since this total output generates an equivalent amount of income for the factors of production, we can say that AS = National Income (Y). On a graph, the AS curve is a 45-degree line from the origin, because at any point on this line, the value on the vertical axis (AS) equals the value on the horizontal axis (Y).

• Aggregate Demand (AD): This is the total planned expenditure in the economy. In a two-sector model, it consists of planned consumption and planned investment.

  $$AD=C+I$$

  As we learned, the consumption function is $C=\bar{C}+bY$. For now, we assume investment (I) is autonomous, meaning it's a fixed amount that doesn't change with income. So, our AD equation becomes:

  $$AD=(\bar{C}+I)+bY$$

  Here, $(\bar{C}+I)$ represents the total autonomous expenditure.

Therefore, the equilibrium condition AD = AS can be written as:

2. Finding Equilibrium: Schedule and Graph

The equilibrium level of income can be determined at the point where the AD curve intersects the 45-degree AS curve. Let's watch a video that illustrates this using both a numerical table (schedule) and a graph.

To summarize what you've just seen, here is a clear image showing both the schedule and the resulting graph.

As the diagram and video illustrate, the equilibrium point is 'E', corresponding to an income level where the total planned spending (AD) exactly matches the total output (AS/Y).

3. The Adjustment Mechanism: What if AD ≠ AS?

A crucial part of explaining equilibrium is detailing what happens when the economy is not in equilibrium. The economy has a built-in mechanism that pushes it back towards equilibrium. This involves changes in inventories. Given your accounting background, you can think of this as changes in the value of closing stock.

Case 1: When AD > AS (Excess Demand)

• What it means: Buyers (households and firms) are planning to buy more goods and services than the firms are currently producing.
• Impact on Inventories: As demand outstrips supply, firms will find their stocks of goods depleting. Their inventories will fall below the planned/desired level.
• Producers' Response: To replenish their inventories and meet the higher demand, firms will increase production.
• Result: Increased production leads to more employment and higher national income (Y). This process continues until income (Y) rises enough to make AS equal to AD, restoring equilibrium.

Case 2: When AD < AS (Deficient Demand)

• What it means: Buyers are planning to buy fewer goods and services than what firms are producing.
• Impact on Inventories: Since goods are not selling as expected, firms will face an unplanned accumulation of inventories. Their stock of unsold goods will rise above the desired level.
• Producers' Response: To clear this unwanted inventory and adjust to lower demand, firms will cut back on production.
• Result: Decreased production leads to lower employment and a fall in national income (Y). This process continues until income (Y) falls enough to make AS equal to AD, restoring equilibrium.

Let's watch a detailed explanation of this crucial adjustment process.

4. Key Assumptions and How to Structure Your Answer

For a complete exam answer, you should also mention the underlying assumptions of this model and structure your answer properly.

Key Assumptions:

• The analysis is done in the context of a two-sector economy (households and firms).
• Investment (I) is autonomous; it does not change with the level of income.
• The general price level is assumed to be constant.
• The analysis applies to the short-run.

To learn how to best present this topic in your exam, let's get some tips on structuring a long-form answer.

Your Turn: Check Your Understanding

Now, let's apply the equilibrium condition to a numerical problem. This is a direct application of the concept and a great way to practice for the exam.

Problem:
Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (Ā) is ₹ 50 crores, MPS is 0.2, and the level of income (Y) is ₹ 4000 crores. State whether the economy is in equilibrium or not.
(Note: Ā represents total autonomous expenditure, which is $\bar{C}+I$.)

Think through the steps:

1. Find MPC from the given MPS.
2. Write down the AD equation using the values provided.
3. Calculate the value of AD at the given income level.
4. Compare the calculated AD with the given level of AS (which is Y).
5. Conclude whether the economy is in equilibrium.

After you've tried it, you can check your method against the solved solution in the resource below.

(Based on your calculation, you should find that AD = ₹ 3250 crores while AS = ₹ 4000 crores. Since AD < AS, the economy is not in equilibrium.)

Conclusion

In this lesson, we have thoroughly examined how equilibrium income is determined using the AD-AS approach. This is a foundational concept in Keynesian economics and a high-frequency question in your board exams.

Key Takeaways:

• Equilibrium occurs where planned aggregate spending equals total output: AD = AS.
• In a two-sector economy, this translates to Y = C + I.
• Graphically, equilibrium is at the intersection of the AD curve and the 45-degree AS line.
• If AD > AS, inventories fall, leading firms to increase production, which raises income back towards equilibrium.
• If AD < AS, inventories rise, leading firms to decrease production, which lowers income back towards equilibrium.

In our next lesson, we will explore the second method for determining equilibrium: the Saving-Investment (S-I) approach. You will see that it's just another way of looking at the same equilibrium condition and will yield the exact same result.