Question

(a) Draw an AS-AD chart showing the economy initially in AS-AD equilibrium. Next, suppose the price level target is raised. Using your AS-AD chart, illustrate the effect on the economy in the short run. Briefly explain, with reference to the chart.

Answer 1

Ans. Market Equilibrium refers to the point which has come to be established under a given condition of demand and supply and has tendency to stick to that level that is Demand = Supply.

From the above diagram OX axis represents Quantity demanded and Supplied

OY axis represents Price

DD is the aggregate demand curve and SS is the aggregate supply curve.

Aggregate supply curve is upward sloping because it is directly related to the price. When price increases, quantity of production also increases as a result supply also increases. Hence Supply curve is upward sloping.

Demand curve curve is down wordsloping because demand and price are inversely related.

From the above diagram it is clear that the Equilibrium point is 'E' where the aggregate demand for the commodity and aggregate supply of the commodity intersect each other. In this point AD = AS.(Aggregate Demand is equal to Aggregate supply)

Both consumers and Producersobjectives are satisfied in this equilibrium point.

The Price 'P' is the equilibrium price.

When the Price increases from ' P' to P1 then the demand for the commodity will be less than the supply. That means there is Excess supply in the market. Then there is a change in the Equilibrium point.

Inorder to dispose the excess supply the sellers will compete each other and in doing so, they will bring down the price to OP level . Thus if Price is below or above the equilibrium price, the demand and supply force will operate.

From the above diagram , it is clear that when price increases from P to P1 demand decreased and supply increased.

In the macro economic context, the intesection of aggregate demand and aggregate supply determines the short run equilibrium output and price level. When the aggregate amount of output demanded is equal to aggregate amount of output supplied.

Once we reached in the shortrun equilibrium, if current GDP is less than the full employment output , that economy is in recession. If current real GDP is higher than the full employment output, it shows the economy is in Boom situation.

When the quantity of aggregate output demanded is equal to aggregate output supplied this level is the equilibrum level and at what price level the equilibrium point is, that price is the equilibrium price.

The quantity of aggregate output produced in the shortrrun output equilibrium, the real GDP will exist (AD = AS). If price increases, producers will be happy to produce more goods and services and it will contnue till the amount of aggregate production is equal to the amount of aggregate demanded.