Why does the price level increase when aggregate demand increases?
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This is for the same reason that increased demand leads to higher prices in microeconomics.
The idea is that there is greater demand, which means that there are more people who are willing to buy a given product. When that happens, the people are typically willing to pay higher prices because they know that if they do not pay that price, someone else will and the product will be gone.
So when there is more demand, there is more "money chasing goods" and the prices have to rise and you end up with demand-pull inflation.
This is the basic principle of supply and demand and is at the heart of any market-based economy. Essentially, you must look at supply as the quantity that is available of a given product. Demand refers to the relative number of people who want that product. The greater the demand, the harder it is for the supply to meet that demand. Producers can only create a certain amount of any one product in a given amount of time and with a sometimes limited set of resources needed to create that product. As a result, quantities (supplies) are limited, making them more valuable and, consequently, making people who can afford to pay more willing to pay more. Sometimes, even people who cannot afford to pay are willing to pay the price if the demand is great enough. Conversely, when the supply ourweighs the demand, you end uo with a surplus. The suppliers have created a product that consumers are not purchasing rapidly enough. In this case, proces will be dropped in order to encourage people to buy the product and reduce the supply.
For a look at some relevant graphs explaining the process, see the following resource:
The market equilibrium price is the price at which the quantity demanded for purchase by consumer equals the quantity offered by suppliers for sale are equal. All other things being equal the buyers are willing to buy less as the price increases. while the sellers are willing to manufacture and sell more as the price rises. Thus quantity offered for supply rises with rise in price, while quantity demanded for purchase decreases with rise in price. With the result there is only one price at which the demand and supply is exactly equal. This represents market equilibrium price and quantity.
If we relax the condition of "everything else being equal" the quantity offered for supply or demanded for purchase at various prices can change also. This is called shift in the supply and demand curves. When we say the aggregate demand has increased we are actually describing a situation in which, because of change in some other condition such as increase in disposable income, buyers are willing to buy more quantities at each price level, or conversely are willing to pay higher prices for the same quantity offered for supply. This is kind of change in basic pattern of demand and supply is described as shift in demand and supply curves.
When the demand increases the demand curve shifts to the right. As there is no change in the supply. the supply curve remains same. As a result the new equilibrium price is reached at a higher level. In this way an increase in demand causes market equilibrium prices to increase.
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