Relationship between price level and aggregate demand

Aggregate demand and aggregate supply curves (article) | Khan Academy

relationship between price level and aggregate demand

Prices coordinate supply and demand, and they are also determined by it. There is no clean, direct link between aggregate demand and. There are a number of reasons for this relationship. Recall that a downward sloping aggregate demand curve means that as the price level drops, the quantity of. A rise in price level will cause a decrease in aggregate expenditures and a down, showing a negative relationship between price and aggregate expenditures.

Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply. Like the demand and supply for individual goods and services, the aggregate demand and aggregate supply for an economy can be represented by a schedule, a curve, or by an algebraic equation The aggregate demand curve represents the total quantity of all goods and services demanded by the economy at different price levels.

An example of an aggregate demand curve is given in Figure. The vertical axis represents the price level of all final goods and services. The horizontal axis represents the real quantity of all goods and services purchased as measured by the level of real GDP. Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP.

The demand curve for an individual good is drawn under the assumption that the prices of other goods remain constant and the assumption that buyers' incomes remain constant. As the price of good X rises, the demand for good X falls because the relative price of other goods is lower and because buyers' real incomes will be reduced if they purchase good X at the higher price.

The aggregate demand curve, however, is defined in terms of the price level. A change in the price level implies that many prices are changing, including the wages paid to workers. As wages change, so do incomes. Consequently, it is not possible to assume that prices and incomes remain constant in the construction of the aggregate demand curve.

relationship between price level and aggregate demand

Three reasons cause the aggregate demand curve to be downward sloping. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy. Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell.

The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level. The graph below shows an aggregate supply curve.

relationship between price level and aggregate demand

Let's begin by walking through the elements of the diagram one at a time: The aggregate supply curve The graph shows an upward sloping aggregate supply curve. The slope is gradual between 6, and 9, before become steeper, especially between 9, and 9, The vertical axis shows the price level. Price level is the average price of all goods and services produced in the economy.

It's an index number, like the GDP deflator. Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services supplied—rises as well. Why do you think this is? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy, not the price level for intermediate goods and services that are inputs to production. The AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while the prices of inputs like labor and energy remain constant.

If firms across the economy face a situation where the price level of what they produce and sell is rising but their costs of production are not rising, then the lure of higher profits will induce them to expand production. Potential GDP If you look at our example graph above, you'll see that the slope of the AS curve changes from nearly flat at its far left to nearly vertical at its far right.

At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP—the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions. Thus, the slope of demand curve of an individual commodity depends mainly on the possibility of substitution between the commodities. On the other hand, as we shall see below, the slope of aggregate demand curve depend on factors totally different from those that cause demand curve of an individual commodity to slope downward.

We have drawn an AD curve in aure As will be seen from Figure It is important to note that the AD-AS model is unlike that of market demand-supply model of microeconomic theory. When we consider demand and supply in a particular market, say for cotton cloth, rise in its price will cause increase in its quantity supplied but in doing so resources will be withdrawn from other goods.

Such reallocation of resources between products and consequently rise in output of one product and fall in that of the other is not considered in macroeconomics where we are concerned with determination of aggregate output, total employment of resources in the economy as a whole.

Similarly, in macro- economic model of aggregate demand and aggregate supply we study the determination of general price level and does not explain the relative prices of various products.

We explain below in detail the concepts of aggregate demand AD and aggregate supply AS curves and their likely shape and factors determining them.

We will also discuss some important controversial issues of macroeconomics with this AD-AS model. Why Aggregate Demand Curve Slopes downward? The aggregate demand curve shows graphically the relationship between total spending and price levels and it slopes downward to the right. This means that at higher price levels, the total spending or quantity of aggregate output purchased or demanded is less and at lower price level the total spending or total purchases of aggregate output of goods is higher.

This is depicted in Figure Aggregate output demanded per period of time is measured along the X-axis, and the general price level along the Y-axis. It should be carefully understood why aggregate demand for output or total spending falls at higher aggregate price level and increases at lower price levels, or, in other words, why aggregate demand AD curve slopes downward. The following factors are responsible for this. First, the changes in the general price level affect the real value or purchasing power of money balances and monetary assets with fixed nominal values such as bank deposits, bonds, etc.

With the rise in the general price level, the real value of these monetary assets will fall making people feel poorer than before. This induces them to consume less and therefore lead to the decline in quantity of output purchased by them. Conversely, if the price level falls, the real value of their monetary assets increases inducing them to buy more. This is called real balance effect of the change in the price level.

Rate of Interest Effect: Secondly, another important reason for the downward sloping nature of aggregate demand curve is the effect of change in general price level on the rate of interest and through it on investment demand.

Aggregate Demand (AD) Curve

At a higher price level, the people will require more money for conducting a given amount of transactions. This will lead to the increase in the demand for money for making transactions. Given the money supply, the increase in demand for money for transaction purposes will cause the rate of interest to go up. At a higher rate of interest, demand for investment in new capital goods i.

At the lower rate of interest, investment demand will increase.

Aggregate Demand and Aggregate Supply with Flexible Price Level

To conclude, the investment demand and the general price level are also inversely related. This is called foreign trade effect of the change in price level. If a general price level in India falls, its exports will become cheaper leading to their increase. On the other hand, the lower price level in India will induce India people to buy Indian goods instead of imported ones.

On the contrary, a rise in price level in India will lead to decline in its exports i. Thus, rise in price level, that is, inflation will cause a decline in net exports. To sum up, the quantity of aggregate demand for consumption, investment and net exports increases with a fall in the price level and declines with a rise in the price level. This means that aggregate demand curve showing relationship between aggregate output demanded and the general price level slopes downward to the right as is shown in Figure As has been explained above, a change in the price level causes a change in the quantity demanded through producing three effects, namely, real balance effect, interest rate effect, and foreign trade effect.

Let us suppose the price level falls. As explained above, with a lower price level real purchasing power of the money balances or financial assets with fixed nominal values held by the people will increase. As a consequence, the people will start feeling themselves richer. Thus lower price level will induce people to consume more at each level of national income.

This is illustrated in Figure In panel a at the top of this figure, we have shown the determination of equilibrium level of real national income i. At the level Y0 of GNP, planned aggregate expenditure is equal to the value of aggregate national output. Thus, at the initial price level P0 the equilibrium quantity of aggregate output demanded is Y0. Therefore, in the panel b of Fig. Suppose the price level falls from P0 to P2.

With this real purchasing power of the money balances and financial assets held by the people will increase and they will be induced to consume more than before.

Aggregate demand and aggregate supply curves

It will be seen from panel a of Figure Thus, in panel b at the bottom we show aggregate output Y2 against the lower price level P2. This shows that at a lower price level, more aggregate output is demanded. Now, suppose instead of fall in price level the price level rises from P0 to P1 At a higher price level, the real value of money balances and financial assets with fixed nominal value will decrease.

As a result, people will feel poorer than before causing them to spend less on consumption than before at each level of national income. It will be seen from the upper panel a of Fig.

relationship between price level and aggregate demand

Accordingly, against a higher price OP1 we plot a smaller aggregate output demanded Y1. It will be seen from the panel b at the bottom of Fig.

We have derived above aggregate demand curve with flexible prices by considering the effect of changes in price level on consumption function and through it on aggregate expenditure curve, Similarly, we can consider the effect of changes in price level on two other components of aggregate expenditure, such as investment demand I and net exports Xn. Thus, when price falls, less money will be required to meet transaction motive of demand for money.

As a result, with a fall in price, demand for money will decrease and, given the money supply, this will cause the rate of interest to fall.

relationship between price level and aggregate demand

At a lower interest rate, investment will increase causing the aggregate expenditure curve to shift above and determine a higher level of equilibrium aggregate output demanded.

Conversely, the rise in price level will require more money for transaction purposes and therefore demand for money will increase causing rate of interest to rise, money supply remaining unchanged. A rise in interest rate will thus bring about decrease in investment demand which will shift the aggregate expenditure curve downward and thus lower the aggregate output demanded. Similarly, changes in the price level affect exports X and imports M and will therefore cause change in net exports Xn.

For example, a fall in the domestic price level causes exports to go up and imports to decline.

Aggregate Demand and Aggregate Supply with Flexible Price Level

Shift in Aggregate Demand Curve: As in micro-economic analysis of demand, it is important to know the factors that cause a shift in aggregate demand curve. We have derived above an aggregate demand curve from the shifts in aggregate expenditure curve caused by changes in price level. Now, when some factors other than the price level change which cause shifts in aggregate expenditure curve, they will cause a shift in aggregate demand curve, that is, they will cause increase or decrease in aggregate output demanded at each price level.

In our above analysis of derivation of aggregate demand curve we assumed Government expenditure Gtaxation Iinvestment autonomous of price change I and money supply M constant as they were treated as autonomous of changes in price level. When these non- price factors change, aggregate demand curve will shift.

We explain below how this non-price factors cause a shift in aggregate demand curve. Consider an increase in Government expenditure. This will lead to shift in aggregate demand curve to the right as Government expenditure is an important component of aggregate demand. With this rightward shift in aggregate demand curve, more aggregate quantity of output will be demanded at each price level.

On the other hand decrease in Government expenditure will have an opposite effect. Further, expansion in money supply as a part of expansionary monetary policy will also cause a rightward shift in aggregate demand curve as shown Fig. Similarly, if expectations or sentiments of the entrepreneurs about profit prospects favourably change they will cause increase in investment demand leading the increase or rightward shift in aggregate demand curve.

Another important factor causing a shift in demand curve is changes in net exports i. If there is increase in incomes abroad, the demand for our exports will increase.

Given our imports, the increase in net exports will cause a shift in aggregate demand curve to the right. Similarly, if the rate of exchange rate of our currency rupee falls, that is, if there is depreciation of our currency our exports will become cheaper and imports dearer than before.

This will cause an increase in our net exports leading to the shift in aggregate demand curve to the right.

Similarly, increase in money supply M will cause a rightward shift in aggregate demand curve. In the derivation of a given aggregate demand curve, money supply in the economy is held constant. If at a given price level, money supply is increased, the interest rate will fall.

The fall in interest rate will cause investment demand to increase. Aggregate output demanded will thus be greater at the given price level. Thus, expansion in money supply brings about shift in aggregate demand curve to the right.

The same logic applies to the effect of contractionary fiscal and monetary policies. A decrease in Government expenditure or increase in taxes will cause AD curve to shift to the left. Similarly, decrease in investment autonomous of any change in the price level will also shift the AD curve to the left. Similarly, contraction in money supply M at a given price level will lead to the leftward shift in the aggregate demand curve.

It will be recalled that increase in Government expenditure or investment has a multiplier effect on aggregate output demanded depending on the size of multiplier.

As in case of increase in Government expenditure, reduction in taxes will also increase aggregate output demanded at each price level and will therefore cause a shift in aggregate demand curve.

Aggregate supply is the total output of goods and services that firms want to produce at each possible price level. It may be noted while drawing aggregate supply curve that depicts relationship been quantities produced for sale in the market of aggregate output that are by the firms in the economy at various price levels, all other factors that affect aggregate supply being held constant.

There is a lot of disagreement among economists about the shape of aggregate supply curve. The classical economists assumed that there normally prevailed full employment of resources in the economy.

According to them, if at any time there is deviation from this full employment level, the wages, interest and prices quickly and automatically adjust and change to restore equilibrium at the full employment level. Thus, in the classical theory, the aggregate supply curve of output is perfectly inelastic i. This aggregate supply curve relating aggregate supply with price level of the classical theory of income and employment is shown in Figure As mentioned above, Keynes considered the situation of economic depression when the economy was operating before the level of full employment of resources.

He further believed that in such a situation money wage rates were sticky i. He further assumed that average and margined products of labour remain constant when more of it is employed following the increase in aggregate demand. With these assumptions, more aggregate output is produced and supplied at the given price level in response to increase in aggregate demand. But when full employment of labour and capital stock is attained and aggregate demand further increases, aggregate supply curve being unable to increase any more, it is the price level that will rise in response to the increase in aggregate demand.

It may however be noted that Keynes reorganised that as the aggregate supply approaches close to the full-employment level the cost of output per unit tends to rise due to the rise in wage rate and also due to diminishing returns to extra factors employed.

relationship between price level and aggregate demand

But, according to Keynes, the rise in price full-employment level before full employment or less than capacity output will not be much. It is evident from above that shape of aggregate supply curve is a highly controversial issue. As mentioned above, aggregate supply curve indicates the total output which the producers are willing and able to sell at different price levels. It is important to note that as the average price level rises above the current marginal cost of production, producers find it profitable to expand output.