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CHAPTER 4 : AGGREGATE DEMAND AND AGGREGATE SUPPLY

4.1 Aggregate Demand

(A) Meaning: Aggregate demand is the total demand made by all members of the society for all goods and services. In macroeconomic analysis such aggregate demand is a function of the general level of prices. Here, the price of any individual good or the demand for it from an individual member is not under consideration. In fact it is the demand for all goods and its dependence on the level of all prices that is being analyzed. Such a general level of prices is in the form of a price index which is usually Consumerís Price Index or CPI. The demand on the other hand represents demand for real national income which can be denoted as Yr.

Aggregate Demand (AD) is then a function of the price level (P) and the relation between the two can be expressed in the form of a schedule. By scheduled pairs of prices and AD quantities we mean that at arbitrarily given prices, expected quantities demanded are related. On the basis of a demand schedule, as shown below, we can also represent it graphically.

                                                                       CURVE

AD Schedule

Price level

AD quantities or Yr

6

10

5

12

4

18

3

30

2

44

1

60

In the AD Schedule we notice an inverse relationship between level of prices and the quantities or real income. As the price level falls (through 6 to 1) Aggregate Demand goes on increasing (from 10 through 60). In the figure, the same information has been presented graphically (in the form of the AD curve). In the figure price has been measured along the vertical and AD quantity along the horizontal axis. The inverse relation between the two is apparent since the AD curve slopes downwards.

(B) Inverse Relationship: In case of the individual demand curve the price - quantity relation is inverse and hence the demand curve slopes downwards. This is because of both substitution effect which is negative and income effect which is positive. In such cases we concentrate only on the changes in the price of a single commodity, assuming prices of all the substitute goods to be constant. Therefore the good (say X) for which price rises, becomes relatively dearer, and part of its demand is shifted to other substitutes which are relatively cheaper. Therefore the demand for good X falls. On the other hand, with rise in the price, the consumerís real income falls since the purchasing power of his money income decreases (he will have to shell out more money to buy the same amount of good X at its higher price). Hence his demand for good X decreases. Therefore both price and income effects cause demand to fall with a rise in the price of a good.

However, in case of changes in aggregate demand and general price level such a simple relation does not hold good. In this case since prices of all the goods are rising simultaneously there cannot be any substitution effect. Moreover, with rising price level money income of labor and other factor owners who provide their services is likely to go up. Therefore, their capacity to spend is likely to increase and demand for goods may actually rise, instead of falling, or may at least remain constant even with a rise in price level. For this reason, the inverse relationship (downward sloping curve) of the aggregate demand curve cannot be explained with the same reasoning as that of the individual demand curve. Yet the price level and aggregate demand continue to hold a negative or inverse relation because of the presence of the three distinct effects.

Index

4.1 Aggregate Demand
4.2 Aggregate Supply
4.3 Equilibrium

Chapter 5

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