explain automatic adjustment mechanism .
Automatic adjustment mechanism is a mechanism that operates automatically when the market deviates from the equilibrium. It operates in the market till the equilibrium is reattained. The automatic adjustment mechanism operates in the following two situations.
1) When Aggregate Demand exceeds Aggregate Supply (AD > AS)
When AD>AS, it implies a situation of excess demand. In such a situation, producers increase their production to meet excess demand.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 as shown in the above diagram. Hence, excess demand is adjusted by automatic adjustment mechanism.
2) When Aggregate Supply exceeds Aggregate Demand (AS > AD)
When AS>AD, it implies a situation of deficient demand or excess supply.In such a situation, producers experience piling-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 as shown in the above diagram. In this case also, automatic adjustment mechanism helps the economy to overcome deficient demand.
1) When Aggregate Demand exceeds Aggregate Supply (AD > AS)
When AD>AS, it implies a situation of excess demand. In such a situation, producers increase their production to meet excess demand.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 as shown in the above diagram. Hence, excess demand is adjusted by automatic adjustment mechanism.
2) When Aggregate Supply exceeds Aggregate Demand (AS > AD)
When AS>AD, it implies a situation of deficient demand or excess supply.In such a situation, producers experience piling-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 as shown in the above diagram. In this case also, automatic adjustment mechanism helps the economy to overcome deficient demand.