Page 2 - Lesson Note 46 (1)

Aggregate demand (AD) and aggregate supply (AS) curves intersect at

point E, which indicates the full employment equilibrium.

Due to increase in investment expenditure (∆I), aggregate demand rises

from AD to AD 1. It denotes the situation of excess demand and the gap
between them, i.e., EF is termed as inflationary gap.

Reasons for Excess Demand:

Excess demand may arise due to several factors. Important, among
them, are mentioned below:

1. Rise in the Propensity to consume:

2. Reduction in taxes:

3. Increase in Government Expenditure:

4. Increase in Investment.

5. Fall in Imports:

6. Rise in Exports:

7. Deficit Financing:

Impact of Excess Demand:

Excess demand is not a desired situation because it does not lead to any
increase in level of aggregate supply as the economy is already at full
employment level. Excess demand has the following effect on output,

employment and general price level:

1. Effect on Output:

Excess demand does not affect the level of output because economy is

already at full employment level and there is no idle capacity in the economy.

2. Effect on Employment:

There will be no change in the level of employment as the economy is
already operating at full employment equilibrium and there is no involuntary
unemployment.