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Question
Discuss the situation when aggregate demand is more than aggregate supply at full employment income level.
Solution
If the actual aggregate demand for output (ADE) is above the aggregate supply shown by the 45 degree line at the full employment level of output then there exists excess demand.
In other words, excess demand refers to a situation where the aggregate demand for output is more than the full employment level of output.
Due to the excess of aggregate demand, there exists a difference (or gap) between the actual level of aggregate demand and full employment level of demand. This difference is termed as inflationary gap. This gap measures the amount of surplus in the level of aggregate demand. Graphically, it is represented by the vertical distance between the actual level of aggregate demand (ADE) and the full employment level of output (ADF). In the figure, EY denotes the aggregate demand at the full employment level of output and FYdenotes the actual aggregate demand. The vertical distance between these two represents inflationary gap. That is,
FY – EY = FE (Inflationary Gap)
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