Aggregate Demand and Aggregate Supply approach (AD and AS approach). Under this approach, the equilibrium level of income is determined at the point where Aggregate Demand (AD) is equal to Aggregate Supply (AS).
In this diagram, consumption curve is depicted by C and the investment curve is depicted by the horizontal straight line parallel to the output/ income axis. Summing-up the investment curve and consumption curve, we get the Aggregate Demand curve represented by AD=C+L. The Aggregate Supply curve is represented by the 45∘ line. Throughout this line, the planned expenditure is equal to the planned output. The point E is the equilibrium point, where the planned level of expenditure (AD) is equal to the planned level of output (AS). Accordingly, the equilibrium level of output (income) is OQ.
In case, if AD>AS, then it implies a situation, where the total demand for goods and services is more than the total supply of the goods and services. This implies a situation of excess demand. Due to the excess demand, the producers draw down their inventory and increases production. The increase in production requires hiring more factors of production, thereby increases employment level and income. Finally, the income will rise sufficiently to equate the AD with AS, thus the equilibrium is restored back.
On the other hand, in case, AS>AD, then it implies a situation, where the total supply of goods and services is more than the total demand for the goods and services. This implies a situation of deficit demand. Due to the deficit demand, the producers experience pilling-up of stock of unsold goods, i.e., inventory accumulation. This would force the producers to cut-back the production, thereby results in the reduced employment of factors of production. This leads to fall in the income and output. Finally, the income and output will fall sufficiently to equate the AD with AS, thus the equilibrium is restored back.