What this lesson teaches
I can use AD and AS to find the equilibrium national output and general price level.
Syllabus 8843, 3.1.1(d). Aggregate Demand and Aggregate Supply: How interaction of AD and AS determines equilibrium level of national output and general price level
Make a guess
Unsold stock piles up in warehouses across the economy. What do firms usually do next?
- Cut production, which lowers incomes and spending.
- Keep output the same, because the economy settles back into equilibrium.
- Raise production, to have more to sell later.
Show the answer
Cut production, which lowers incomes and spending.
Rising stock tells firms that output is above planned spending. They produce less and hire fewer workers until output matches spending.
If spending and output do not match, stock levels change and firms adjust output until they do.
Equilibrium is where planned spending (AD) equals output (AS). Firms sell what they planned to produce.
If output is greater than planned spending, unsold stock piles up. Firms cut production and may cut prices, so output falls towards equilibrium.
If planned spending is greater than output, stocks run down. Firms raise production and may raise prices, so output rises towards equilibrium.
This adjustment takes time. Firms first notice changes in their stock levels, then change production and hiring.
- Equilibrium
- Planned spending equals output.
- Signal
- Changes in unsold stock.
Worked example: When spending falls short
Suppose firms produce output worth an index of 110, but planned spending at the current price level is only 100.
- Firms cannot sell everything they produce, so unsold stock builds up.
- They cut production and hiring.
- Lower production means lower incomes, which reduces spending further for a time.
- The economy moves to a new equilibrium where output matches planned spending.
Watch out for this
The economy is always at equilibrium.
Adjustment takes time. In the meantime, stocks pile up or run down, and output and prices change.
Check your understanding
Firms find their unsold stock rising unexpectedly. What are they likely to do?
- Increase production.
- Raise prices.
- Cut production.
Show the answer
Cut production.
Right. Rising stocks show output is greater than planned spending.