Describe the adjustment mechanism if Aggregate Demand (AD) is less than Aggregate Supply (AS).

Question

Accepted Answer

When Aggregate Demand (AD) is less than Aggregate Supply (AS), there is excess supply in the economy. This leads to the following adjustment mechanism:

**Step 1: Inventory Accumulation**
Since AD < AS, firms produce more than what is demanded. This leads to unplanned accumulation of inventories (stocks of unsold goods).

**Step 2: Production Cut**
Firms respond to inventory accumulation by reducing production. They cut down output to match the lower level of demand.

**Step 3: Income and Employment Fall**
As production decreases, factor payments (wages, rent, interest, profit) decline. This reduces national income and employment in the economy.

**Step 4: New Equilibrium**
The process continues until AD = AS, i.e., until the economy reaches a new equilibrium where planned expenditure equals planned output.