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The relationship between aggregate demand and inflation is the effect that the general or combined types of demand in the economy have on the level of inflation. Demand comes from many sources within the economy, including the demand for and consumption of goods and services by individual consumers within a particular economy as well as the consumption by companies. Government and the external demand flowing from outside sources are also factors. All of these contribute to the link between aggregate demand and inflation within the economy.
Consumption by individuals make up an important percentage of the aggregate demand within an economy. This is in addition to demand by companies in the form of supplies for their businesses and materials for the construction of 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 demand contributions from outside sources include exports to other countries and consumers outside the country.
The sum total of all of these forms of demand make up the aggregate demand model, and the level of demand usually varies at different points in the business cycle calculations. A desirable balance between aggregate demand and supply in an economy is one where the level of demand is at a steady rate with the level of supply. This link between aggregate demand and inflation can be seen where the level of aggregate demand rises faster than the supply of goods and services.
A connection between aggregate demand and inflation stems 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 the aggregate demand. The result of a such a lopsided balance in the demand and supply equation is a steady rate of inflation, while the supply continues to fall below the rate of demand. In such a situation, the government may step in to redress this imbalance through the application of targeted fiscal policies. The major monetary authority within that economy may also apply its own policies in a bid to reverse the inflationary trend.
An illustration 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 cost about $25 US Dollars (USD) when the level of demand is constant, this level will change when the demand outweighs the supply. For instance, if the aggregate demand for oranges increases to a level that outstrips the supply, the price for the same basket of oranges could increase to $50 USD, substantially more than the previous price.