Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

 
9.3.2 Equilibrium Price Level: 
 
The equilibrium price is obtained at point where Aggregate 
Demand (Macroeconomic Demand Schedule) intersects the 
Aggregate Supply Schedule as curve is vertical in Classical model. 
FIGURE 9.6: DETERMINATION OF EQUILIBRIUM PRICE LEVEL 
0
*
Y
Pr iceLevel
T
K
1
P
P
AS
MDS
E
Output

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The equilibrium price level is OP where MDS = AS. OP is the 
price which clears the market for goods, money and labour 
simultaneously.
Labour market is in equilibrium any where on Classical AS 
curve. But at ‗E‘ we are also on MDS, along which goods market 
and money market are in equilibrium. 
Suppose prices were higher than OP than the real money 
supply would be lower and the interest rate higher hence, the 
aggregate demand would be lower. Therefore, at P
1
price 
aggregate demand is lower at P
1
T. However, the aggregate supply 
is P
1
K. There is excess supply which firm wish to sell, given as TK. 
In the Classical model, the firm reduce the price to increase the 
demand. As the prices fall real money balances rise, interest rate 
fall and leads to an increase in aggregate demand. The process 
continues until equilibrium point E is attained. 
On the other hand, if prices are below OP
1
, real money 
supply would be higher, interest rate lower and aggregate demand 
would exceed the potential output Y*. The excess demand pushes 
up the prices and returns the economy at equilibrium point E.
9.3.3 Factors which determines equilibrium price: 
 
The equilibrium price P depend on number of factors selected in 
the position of MDS and as a schedules. On the supply side, the 
level of potential output is Y* depend on supply and demand for 
labour. The aggregate supply will shift to the right due to the 
following changes in labour market. 
a) If more worker want to work at each real wage, he labour 
supply curve will shift to the right and the equilibrium level of 
full employment and potential output Y* increases. 
b) Firm have large capital stock; the marginal product of labour 
will rise shifting labour demand schedule to the right. This 
will increase the full employment level of output. Thus an 
increase in willingness to work or increase in stock of capital 
will shift the AS curve to the right. This will reduce 
equilibrium price form P to P
1 
as given in the following 
diagram. 

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