Aggregate demand and inflation are linked as demand from individuals, businesses, government, and external sources contribute to the economy’s demand pattern. An imbalance between demand and supply can lead to inflation, which can be remedied through targeted fiscal and monetary policies. An example is an increase in the price of oranges due to increased demand.
The relationship between aggregate demand and inflation is the effect that the broad or combined types of demand in the economy have on the level of inflation. Demand comes from many sources within the economy, including demand and consumption of goods and services by individual consumers within a given economy, as well as consumption by businesses. Government and external demand from outside sources are also factors. All of this contributes to the link between aggregate demand and inflation within the economy.
Consumption by individuals makes up a large proportion of aggregate demand within an economy. This adds to the demand from companies in the form of supplies for their businesses and materials for building new plants and other facilities. The government also contributes to the aggregate demand in the economy through its spending on goods and services for the general public and for government officials and workers. Aggregate contributions to demand from external sources include exports to other countries and consumers outside the country.
The sum total of all these forms of demand forms the aggregate demand pattern, and the level of demand usually varies at different points in business cycle calculations. A desirable balance between aggregate demand and supply in an economy is one in which the level of demand is in a constant rate with the level of supply. This link between aggregate demand and inflation can be seen where the level of aggregate demand increases faster than the supply of goods and services.
A connection between aggregate demand and inflation arises from the fact that excessive demand for limited goods and services leads to a situation where the value of those goods and services will increase substantially due to the burden of aggregate demand. The result of such a lopsided balance in the supply and demand equation is a constant rate of inflation, while supply continues to fall below the demand rate. In such a situation, the government can intervene to remedy this imbalance through the application of targeted fiscal policies. The major monetary authority within that economy can also enforce its own policies in an attempt to reverse the inflationary trend.
An example of the link between aggregate demand and inflation can be seen in the effect that an increase in aggregate demand has on the price of oranges. Assuming that a basket of oranges usually costs around $25 US dollars (USD) when the level of demand is constant, this level will change when demand exceeds supply. For example, if aggregate demand for oranges increases to a level that exceeds supply, the price for the same basket of oranges could increase to $50 USD, substantially more than the previous price.
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