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Derivation of Aggregate Demand Curve when Price Level Varies

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Derivation of Aggregate Demand Curve when Price Level Varies!

To determine the effective demand we considered both aggregate demand function and aggregate supply function in Section 10.5. In aggregate demand function, we showed a relationship between the level of employment and the demand price, i.e., expected sales receipts. In this section, we will derive aggregate demand curve when the price level changes.

A change in price level brings about a change in aggregate demand or expenditure. Here the aggregate demand curve shows the level of national output that will be demanded at each price level. Normally, demand for output is inversely related to the price level.

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This means that when price level rises, households reduce their consumption spending. Businessmen reduce their investment expenditures because higher price level pushes interest rates up. Likewise, net exports will fall if price level rises. A higher price level means expensive exports. Foreigners will buy our products less when the price level rises.

On the other hand, imports become cheaper when price level rises. Thus, in the midst of an increase in price level, export earnings will fall while import bill will increase. This results in a decline in net exports. All these will cause aggregate demand to shift downwards.

In the upper panel of Fig. 10.26, aggregate expenditure line at the price level, denoted by AE (P1), cuts the 45° line at point E1. Equilibrium national income thus determined is OY1. Corresponding to price OP1 OY1 is a point on the aggregate demand schedule in the lower panel of the figure. Now suppose price level rises to P2. This causes aggregate expenditure to decline to AE (P2).

Derivation of Aggregate Demand Curve

As a result, national output declines to OY2. Now, we obtain OY2 on the aggregate demand schedule at a higher price level OP2. By joining these (P – Y) combinations, we get negative sloping aggregate demand curve. Earlier, while deriving aggregate demand curve, we assumed price level constant. Here, as price level is assumed to vary, aggregate demand for national output rises (falls) when price level declines (falls).

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