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 aggregate demand is equal to aggregate supply.
AD = AS
• In the given figure AS represents Aggregate Supply Curve. It forms 45° angle, signifying’ that each point on it expresses the equal value of income and receipts whereas AD represents Aggregate Demand.
• Both i. e., AD and AS intersect each other at the point which is known as the equilibrium point.
• Point E shows that in equilibrium. position level of employment/output/income is OQ and expected receipts are OP.
• When AD > AS
Now suppose the economy is operating at any point before (left of) the equilibrium point.
As the planned spending (AD) is more than planned output (AS) this means consumers and firms together would be buying more goods than the firms are willing to produce.
As a result, the planned inventory would fall below the desired level. Firms would be induced to increase production which will lead to an increase in the level of employment/output/income.
The firms will keep on increasing production until AD = AS.
When AS > AD, Under such a situation the economy will be operating beyond E. As the planned spending is less than planned output (AS) this means consumers and firms together would be buying fewer goods than the firms are willing to produce.
As a result, the planned inventory would rise.
Firms would be induced to decrease production which will lead to decrease in the level of employment/output/income.
The firms will keep on decreasing production till AD = AS.
