Aggregate Demand Inverse Relationship

Aggregate Demand Inverse Relationship - However in case of...

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Aggregate Demand 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 consumer’s 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.
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Unformatted text preview: 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....
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This note was uploaded on 11/17/2011 for the course EC ec 201 taught by Professor - during the Fall '10 term at Montgomery.

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