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

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....

Assumptions

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. It is also assumed that investment expenditure is autonomous, i.e., that income level does not have any impact on investments. It is assumed that the pricing level is constant. Also, to determine equilibrium output, short-run will be considered....

1. 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....

Example:

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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....

Observations:

The equilibrium point, denoted by the letter E, occurs where saving and investment curves intersect each other. Also, at point E, ex-ante saving is equal to ex-ante investment. The equilibrium level of output corresponding to the equilibrium point E is OY. In the above table, planned saving is equal to planned investment; i.e., ₹30 Crores, when the equilibrium level of income is ₹200 Crores....