The intersection need not mean full employment.
In the AD/AS model, equilibrium is the combination of real output and the general price level where planned aggregate expenditure and aggregate supply are consistent. Away from it, unexpected sales, inventories and price pressures can prompt firms to change production and prices. Adjustment is not instantaneous and may differ across sectors. An intersection does not prove full employment, equal outcomes for households or an absence of policy problems. Keep the initial curves, the changed determinant and the new equilibrium distinct when explaining a shock.
- Intersection
- Equilibrium is the price level and output where planned economy-wide spending and supply are consistent. The AD and AS curves meet at that combination.
- Adjustment
- If sales are weaker than expected, firms can build up unwanted inventories: goods produced but not sold. They may respond by cutting production or prices. Stronger sales can create pressure in the other direction.
- Not necessarily full employment
- Equilibrium can occur while workers or equipment are unused. Potential output is an estimate of what the available resources can sustainably produce; the intersection alone does not establish that level.
Apply the idea
Curve labels
Show the initial and new curves, both equilibria and the corresponding axis values. Label which determinant changed.
Adjustment speed
Prices can be sticky, meaning slow to change because of contracts or firms' decisions. Stocks, expectations, available capacity and differences between industries can also delay the adjustment.
Worked example: When planned spending and supply match
Use AD: P = 200 - Y and AS: P = 50 + 0.5Y. At the initial equilibrium, Y = 100 and P = 100. These are indices, not observed national data.
- Set the two price expressions equal: 200 - Y = 50 + 0.5Y. This gives 150 = 1.5Y, so Y = 100. Substituting into either curve gives P = 100: planned demand and supplied output are consistent.
- At P = 110, planned demand is Y = 90 while the supply schedule gives Y = 120. The mismatch creates pressure for weaker production or prices rather than proving all offered output will sell.
- At P = 90, planned demand is Y = 110 while supply is Y = 80. Strong demand relative to output offered creates upward pressure on output prices and production.
- The direction of pressure helps explain movement towards an intersection in the model. Actual speed depends on contracts, expectations, capacity and firms' responses.
Watch out for this
The economy must be at full employment wherever AD crosses AS.
The intersection determines model equilibrium. Potential output and employment conditions require additional information.
Check your understanding
If firms unexpectedly accumulate unsold inventories, which response is plausible, other things equal?
- They must permanently increase production by the stockpile.
- They may reduce production or prices as they revise plans.
- The accounting identity proves the stocks cannot exist.