Question

2. Draw an AE diagram and illustrate and explain what occurs when actual output is more than desired expenditures

Answer 1

AE is the planned/desired expenditure of the economy. In the AE graph we draw a 45 degree line we represents the output production line (or the break even line when production equals demand - Y=AE). The AE line has a positive intercept because of positive autonomous consumption, investment and governement expenditure. While the slope of the AE line is given by the mpc. The point where Y line intersects the desired expenditure line AE is the equilibrium level where output Y equals AE - this is at e.

Now when actual output is more than desired expenditure, it means the economy is producing above what is demanded (above potential). This situation is indicated at output level of Y1. At Y1, the actual output is at b point while the desired expenditure is at a. The gap ab repesents the surplus or the excess supply. This situation arises because planned investment was more than desired investment which leads to a positive rise in inventory investment. So for equilibrium to occur again, firms must decrease their investment levels until Y again equals AE.