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Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP.
The demand curve for an individual good is drawn under the assumption that the prices of other goods remain constant and the assumption that buyers' incomes remain constant.
Aggregate Demand (AD) Curve
As the price of good X rises, the demand for good X falls because the relative price of other goods is lower and because buyers' real incomes will be reduced if they purchase good X at the higher price. The aggregate demand curve, however, is defined in terms of the price level. A change in the price level implies that many prices are changing, including the wages paid to workers.
As wages change, so do incomes. Consequently, it is not possible to assume that prices and incomes remain constant in the construction of the aggregate demand curve. Three reasons cause the aggregate demand curve to be downward sloping. The first is the wealth effect. The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time.
As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services.
On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. A second reason is the interest rate effect.
As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise.
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As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP. The slope of an individual demand curve is downward from left to right that indicates the inverse relationship of demand with price.
Let us understand the individual demand curve with the help of an example.
Aggregate Demand (AD) Curve
Prepare a demand curve for the individual demand schedule of product X. The individual demand curve for the demand schedule of X represented in Table-3 is shown in Figure In Figure-4, the DD curve represents the individual demand curve of product X.
Market demand curve can be obtained by adding market demand schedules. Figure-5 shows the market demand curve for the individual demand schedules represented in Table The market demand curve also represents an inverse relationship between the quantity demanded and price of a product.
Let us understand the market demand curve with the help of an example. Ram, Shyam, Sharad, and Ghanshyam are the four consumers of product P. The individual demand schedules for product P by the four consumers at different price levels is represented in Table Determine the market demand curve for product P and prepare a market demand curve for product P.
The market demand for product P can be determined by adding the individual demand schedules, as shown in Table The market demand curve for product P is shown in Figure In Figure-6, the DD curve represents the demand curve of product P. A function can be defined as a mathematical expression that states a relationship between two or more variables containing cause and effect relationship. Similarly, demand function refers to the relationship between the quantity demanded dependent variable and the determinants of demand for a product independent variables.
In the short run, the demand function states the relationship between the aggregate demand of a product and the price of the product, while keeping other determinants of demand at constant. In such a case, the demand function can be expressed as follows: This states that if there is any change in the price of product X, then the demand of product X would also show changes.
However, the demand function does not interpret the amount of change produced in demand due to change in the price of the commodity.
Therefore, to understand the quantitative relationship between demand and price of a commodity, we use the following equation: On the basis of time period, the demand function has been classified as follows: Refers to the demand function in which the change in dependent variable remains constant for a unit change in the independent variable, regardless the level of the dependent variable.
The linear demand function has been represented on graph for Table-6 in Figure Price function can be obtained with the help of demand function by the following equation: Refers to the demand function in which the dependent variable keeps changing with the change in the independent variable.
In the non-linear demand function, the slope of the curve changes throughout the curve.