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Derivation of Aggregate Demand Curve When Price Level Varies (With Diagram)

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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. This means that when the price level rises, house­holds reduce their consumption spending.

Businessmen reduce their investment expen­ditures because higher price level pushes in­terest rates up.

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Likewise, net exports will fall if the 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 the price level rises. Thus, in the midst of an increase in the price level, export earn­ings will fall while import bill will tend to in­crease. This results in a decline in net exports. All these will cause aggregate demand to shift downwards.

In the upper panel of Fig. 3.26, aggregate expenditure line at the initial 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).

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

Derivation of Aggregate Demand Curve When Price Level Varies

Changes in aggregate demand/expendi­ture, such as increases in private investment expenditure, government expenditure ex­ports, etc., cause aggregate demand curve to shift to the right while decreases in these ex­penditures cause leftward shift of the aggre­gate demand curve.

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