Determination of Equilibrium Output
For the determination of Equilibrium output there are 2 approaches:
- AD-AS Approach
- S-I Approach
Let’s learn more about it.
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Aggregate Demand (AD) – Aggregate Supply (AS) Approach
According to the modern theory of income and employment determination. In any economy, at any given time, income and employment are determined at that level where;
AD = AS
As shown below, equilibrium level of income (Y) is determined at the point E, where AD = AS.
Before reaching point E, Aggregate demand is more than Aggregate supply.
Before E; AD> AS
Beyond or after point E, Aggregate supply is more than Aggregate demand.
After E; AD < AS
Now, we will learn how the economy reaches the equilibrium.
Case 1: AD > AS
When AD > AS, this implies that Aggregate supply is less than the Aggregate demand.
So, the flow of goods and services in the economy is less as compare to the demand in the economy.
As a result, the existing stock of producer will be sold out. The producer will start producing more and will continue to increase production till the time, AS becomes equal to AD.
Case 2: AD < AS
When AD < AS, this implies that Aggregate supply is more than the Aggregate demand.
So, the flow of goods and services in the economy exceeds there demand in the economy.
As a result, some of the goods will remain unsold. To clear the unwanted stock, the production will be reduced. AS will be decreased till the time it becomes equal to AD.
Savings (S) – Investment (I) Approach
Under this approach, equilibrium level of income or output is determined at a point where planned savings is equal to the planned investment.
As shown below, equilibrium level of income or output is determined where S = I.
In this diagram, S is the saving curve and I is the investment curve showing autonomous investment. The equilibrium level of income is OY, which occurs at the point E, when S and I curves intersects each other.
The economy will face dis equilibrium if S > I or S < I. Let’s discuss these 2 cases:
Case 1: Savings < Investment (S< I)
If planned savings is less than the planned investment, that is, before point E.
It means that household are consuming more and savings less than what the firm expected them to consume.
As a result, stock would fall and firms will increase the production till the time, Savings becomes equal to the Investment.
Case 2 : Savings > Investment (S > I)
If planned savings is greater than planned investment, that is, after point E.
It means that household are not consuming as much as the firms expected them to consume.
As a result, stock increases. To clear the unwanted stock, the firm will reduce the production till, Savings and Investment becomes equal to each other.
Thank You for reading.
You can read the related post on macroeconomics:
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