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(C) The Three Effects: There are three different effects operating on the aggregate demand as a result of rising price level, or under inflationary conditions. These are Wealth Effect, Rate of interest Effect and Trade Effect.

i) Wealth Effect: Professor A.C. Pigou had first stated and analyzed wealth effect under inflationary conditions of the price level changes. With a rise in the price level, value of the given money income of consumers (assuming supply of money to be constant) decreases. With a fall in the purchasing power of their income consumers become poorer and have to reduce their consumption. By way of an example a person with fixed money income of $100 can purchase 25 units of a commodity, price of the commodity being $4. But he can purchase only 20 units of the commodity when price rises to $5. Thus the real income or wealth of a consumer diminishes from 25 to 20 even when his money income is constant. Such a wealth effect results in the consumer reducing his demand with a rising price level. Contrary would be the case under the conditions of deflation and falling prices. In that case his wealth effect will be positive and enable him to purchase larger quantities of all goods and services. Hence the presence of the wealth effect continues to maintain an inverse relation between price level changes and aggregate demand.

ii) Rate of interest Effect: Rate of interest is also a price like all other prices of goods and services. It is the price paid for the use of money or for the use of loanable funds. Rate of interest also shows a tendency to move upward under inflationary conditions or rising prices. With rising price level and with a constant supply of money, there is an increased demand for liquidity or money and credit resources. This is because the rising price level reduces purchasing power of money. Hence a greater quantity of money is needed to carry out a given volume of transactions. Both households and producers create an increased demand for money under conditions of rising price level. Consequently, with constant supply, growing demand for money tends to raise its price in the form of rate of interest. With higher rates of interest, borrowing becomes dearer and the tendency to save rather than consume is induced. Consequently demand for goods and services both from consumers and investors starts declining. Therefore a rising level of prices results in a fall in the aggregate demand due to a rise in the rate of interest.

iii) Trade Effect: Rising level of prices finally causes fall in the aggregate demand via foreign trade effect. Under the conditions of inflation domestic prices of goods are higher than international price levels. This makes import of goods attractive since import prices are lower and goods are cheaper than domestic products. Again because of an inflationary rise in the prices of export goods, foreign demand for exported goods declines. Both these processes together reduce demand for domestically produced goods and services.

(D) Shifts in Demand: As in the case of the individual demand curve, aggregate demand curve shows a tendency to shift leftward or rightward. The demand curve shifts in this manner when aggregate demand tends to rise without any change in the domestic price level. In other words this occurs when aggregate demand alters for causes other than changes in the price level.

There are a variety of such causes contributing to shifts in aggregate demand. When the public authority increases its expenditure, more purchasing power is put in the hands of people who create an increasing demand. If the rates of taxes are reduced then again people’s capacity to spend increases and aggregate demand will rise. International demand and supply conditions may also contribute to shifts in the aggregate demand curve. Rising price level in countries abroad may make exports of a country relatively cheaper and cause an increased demand for exports. On the contrary under such conditions imported goods become relatively dearer, the demand for which declines and this results in a rise in demand for indigenous products. When all these factors are moving in the opposite direction, they will result in a fall in the aggregate demand and rightward shift in the AD curve.

In figure 11, DD is the original demand curve. On this demand curve at a given price level P1 aggregate demand is of the size q1. But when the demand curve shifts rightward or upward, as D1D1 then at the same price level P1 demand increases from q1 to q2. This means that there has been an increase in demand at the same price. If we consider the higher demand curve D1D1 to be the initial demand curve, then the demand curve DD denotes leftward or downward shift. This time it means that at the same price there has been a decrease in demand.


4.1 Aggregate Demand
4.2 Aggregate Supply
4.3 Equilibrium
Chapter 5

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