How is the equilibrium level of output determined by aggregate demand and aggregate supply? Show this using a diagram.
The equilibrium level of output is determined by the intersection of the aggregate demand (AD) curve and the aggregate supply (AS) curve. In a diagram, the AD curve is typically downward sloping, while the AS curve is upward sloping.
Here is a step-by-step process to illustrate this using a diagram:
1. Draw the horizontal axis to represent the level of output, and the vertical axis to represent the price level.
2. Plot the aggregate demand curve. This curve shows the relationship between the price level and the level of output that all firms in the economy are willing to produce and sell. The AD curve typically slopes downward due to the wealth effect, interest rate effect, and the foreign trade effect. These factors indicate that as the price level increases, the quantity of goods and services demanded by households, businesses, and the government decreases. Label this curve as AD.
3. Plot the aggregate supply curve. This curve shows the relationship between the price level and the level of output that all firms in the economy are willing to produce and sell in the long run. The AS curve is usually upward sloping because as the price level increases, firms are incentivized to produce and sell more output. Label this curve as AS.
4. Locate the point of intersection between the AD and AS curves. This point represents the equilibrium level of output, where aggregate demand equals aggregate supply. Label this point as E and identify the corresponding level of output and price level.
5. Any output level above the equilibrium level will result in an excess supply of goods and services. This will put downward pressure on prices, encouraging firms to reduce production and move back towards the equilibrium level.
Any output level below the equilibrium level will result in excess demand, leading to upward pressure on prices. This will incentivize firms to increase production and move towards the equilibrium level.
In summary, the equilibrium level of output is determined by the intersection of the aggregate demand and aggregate supply curves. This point indicates the level of output where aggregate demand equals aggregate supply, ensuring a balance between quantity demanded and quantity supplied in the economy.