Deriving Aggregate Demand from the AE Model - Online Tutor, Practice Problems & Exam Prep

The aggregate expenditure model illustrates the relationship between total spending in the economy and GDP, highlighting how price levels influence consumption, investment, and net exports. As price levels rise, aggregate expenditures decrease, leading to lower GDP. Conversely, lower prices increase aggregate expenditures and GDP. Additionally, shifts in determinants like investment spending can elevate aggregate expenditures without changing price levels, resulting in a rightward shift of the aggregate demand curve. Understanding these dynamics is crucial for grasping macroeconomic stabilization and the effects of fiscal policy.

Deriving Aggregate Demand from the AE Model

Alright. So we can use our aggregate expenditure model to derive the aggregate demand curve. Let's see how they go hand in hand. Let's recall the aggregate expenditures model, right? The aggregate expenditures; this is the spending in the economy. So you could imagine that demand and spending are very interrelated. The aggregate expenditures model can be used to derive the aggregate demand curve. The big difference between these curves is how price levels affect the curves.

When we think about the aggregate expenditures curve, remember, on this axis, we had aggregate expenditures. So the amount of spending in the economy, and remember, that's equal to consumption plus investment plus government spending plus net exports. Right? The spending in the economy compared to GDP, what we were calling the production in the economy, right? And we were looking for an equilibrium between the production and the spending in the economy, right? But nowhere on this graph do we show price levels. What is the price level in the economy? But the price level determines these factors, right? Just like we've been discussing, the level of consumption is determined by the price level, investment by the price level, and we talked about net exports also being affected by the price level.

But when we move to the aggregate demand graph, we do have the price level on the graph, right? Just like we saw when we first discussed aggregate demand, we saw the price level on the graph, right? We had the price level and the level of GDP on the graph.

So let's go ahead and let's model some different aggregate expenditures and let's see how that can relate to our aggregate demand curve we're going to draw below. So if you recall, we would have some level of aggregate expenditures, and we'll start here and say there's some sort of medium price in the economy. And at this medium price, we would have, we'll say this is aggregate expenditures 1 right here and this is with a medium price. Some medium level of price, and we're going to see what happens when the price goes up and when the price goes down. Right? We would have an economic equilibrium, a macroeconomic equilibrium right here at this level of aggregate expenditures which would be equal to this level of production. So we'll say this is GDP 1 right here, the first level of GDP. And now, let's discuss two other aggregate expenditures.

So what would happen if there were higher prices in the economy? If there were higher prices, do you think this aggregate expenditures would go up or down in this case? So let's think about higher prices. If prices are higher, there's going to be less consumption, less investment, less net exports, right? At these higher prices, all of these things are going to fall. There's going to be less consumption, due to the wealth effect, less investment due to the interest rate effect, less net exports due to the exchange rate effect. By the price level. So what are we going to see happening here? At a higher price, we would have lower aggregate expenditures, because all of those pieces of the puzzle would be smaller. We would have less of all of them. So we'll say this is AE2 at a high price, right? At this higher price, well, look what's happened to our equilibrium. Our equilibrium is much, much lower, right? We have a much lower GDP over here which is at the high price. We have a lower equilibrium GDP.

And then, what about the other situation? What if we had low prices? Well, low prices, well, that's the opposite, right? There's going to be more consumption going on, more investment, and more net exports. So we would have some sort of curve up here and you can kind of see what's following here. We're going to have some higher level of GDP. So at this low prices, we've got this high level of GDP. Right? GDP right there. And this will be aggregate expenditures 3 when the prices are low. Right? So we're the only thing we're changing here is the price level in the economy, and then we're seeing how that affects the aggregate expenditures curve. So now that we've got our three levels of GDP there, let's see how that affects our aggregate demand curve.

So now, let's build an aggregate demand curve based on those three levels of GDP. So I'm going to go down to this graph and remember, this is the price level. So the prices in the economy and this is GDP down here, right? The quantity of GDP that's going to be demanded. So how much production are we demanding based on these different price levels? So in the first case, let's go to the first case where we had a medium price, right? We had a medium price and we had this medium amount of GDP, right? Right in the middle. So what do we have? We'll start right here and say this is price level medium. So maybe that'll be, you know, we'll just put some numbers to it. We'll say this is like a price level of 106 compared to the base here. So at this price medium, we'll put a point right here for the medium amount of GDP. So we're just estimating these here.

So GDP medium. And then what happens when we raise the price level? So at the high price level, notice on this graph when we have the high price level, the high price level, we've got less GDP, right? Less GDP happening at the lower or, excuse me, at the higher prices, there's less GDP. So that's what we're going to see here. If we go and put a higher price, so we'll put a price high over here, say, 112. Well, that price of 112, there's less GDP demanded. So we'll draw a point over here to represent the lower GDP. So notice there's a higher amount of price, but a lower amount of GDP. And this is the GDP at the high price. And then, finally, we've got our third point that we graphed was a low price. So now there's lower prices in the economy. We'll put something down here for price low, and we'll say that's equal to like 102 compared to the base here. And if we go out, just like we saw on our graph, when we had the low prices, it shifted the aggregate expenditures upward. There was more expenditures leading to this higher level of GDP. So with the low prices, we've got more GDP. And what do we have here? So if we put this on the graph right here, representing the lower prices, well, now we've got our aggregate demand curve, right? Based on the different price levels, how much of this GDP is demanded? Which is going to be this line right here, right? Based on the different price levels, we've got different amounts of GDP demanded, and that is our aggregate demand curve, right?

So that's how we can derive the aggregate demand curve from the aggregate expenditures model based on what the different equilibrium GDPs are based on different price levels. Okay? So, we just did a bunch of estimation, but the principle stays the same that, as the price level increases, well, that means aggregate expenditures decrease. Right? The price level is increasing, aggregate expenditures are decreasing. Right? Because each of those, C+G+NX, right? We were seeing this decrease. We see this decrease. So all of those decreasing leads to a lower level of aggregate expenditures, as those prices are higher. Cool? Alright. So that's how we derive the aggregate demand curve. Let's discuss another thing about these two graphs on the next page."

Deriving Aggregate Demand from the AE Model

So now let's say we're holding price levels constant. We were seeing how price levels affected the Aggregate Expenditure Model, leading us to be able to derive that aggregate demand curve. But now let's say that the price level is constant, but there's a change in one of the determinants of aggregate expenditure. And when I say determinants of aggregate expenditure, we're talking still about c+nx. Let's say there's some big boost in investment spending. Investment spending increases, leading to an overall increase in aggregate expenditures. This is what we saw with the multiplier effect. But just in general, if investment goes up, well, we're going to see aggregate expenditures go up. This has nothing to do with the price level, but let's see what this does to the aggregate demand curve.

So let's say this is our original aggregate demand, aggregate expenditures curve right here, AE1, and we're holding price constant. Price is constant. There's no change in price happening, but there is an increase in investment spending. Let's say, maybe, there's some expectation about future profitability, so businesses want to invest more. In that case, we are going to have to shift the AE curve up by the amount of investment spending. We would shift it up for the extra investment spending leading to a new aggregate expenditure curve out here, AE2. But remember, the price is still constant. It's still the same price levels, but there's just been more investment spending in this situation. What do we see? We're going to have this original equilibrium GDP. Remember, this is AE over here. GDP on this axis. We have this equilibrium GDP, GDP1, before we have that increase in spending. And then there's this new equilibrium GDP out here, after the investment spending, that is higher, just like we expect there's some higher level of equilibrium GDP, with the higher aggregate expenditures. There we go.

Now that we see this, how does this relate to our aggregate demand curve? What's happening is, remember, we're holding price levels constant here. So the price is going to stay here. The price level is on this side of the graph, and we've got GDP on this side of the graph. And what did we have? We had our aggregate demand curve that looks something like this. And at this price level, we could say that this was GDP1 right here. In the first situation, the aggregate expenditures 1, this was GDP1 right here on the graph. But what's happened is the price level hasn't changed, but there's a new demand, a new amount of GDP demanded here. It could be something like out here, we have a new point for GDP2. This is going to look similar to what we did with market demands as well. What's happening is the price is being held constant, but something else is shifting our aggregate demand curve. And that's a change in investment spending. So as investment spending goes up, our aggregate demand curve shifts to the right because we're keeping the price level constant, the same level of prices, but there's more GDP demanded at that price and that's because of that increase in the investment spending leading to an increase in the GDP at that price level. Not only can price shift this graph upwards, other things can shift it as well, such as the level of investment spending. When the level of investment spending goes up, we have a shift in our aggregate demand curve. So that's how the aggregate expenditures model that we've learned previously correlates with this model of the Aggregate Demand and Aggregate Supply together. Knowing that, let's go ahead and move on to the next video.

Here’s what students ask on this topic:

How does the aggregate expenditure model relate to the aggregate demand curve?

The aggregate expenditure (AE) model and the aggregate demand (AD) curve are closely related. The AE model shows the relationship between total spending in the economy (consumption, investment, government spending, and net exports) and GDP. When price levels change, they affect these components of spending. Higher prices reduce consumption, investment, and net exports, leading to lower aggregate expenditures and GDP. Conversely, lower prices increase these components, raising aggregate expenditures and GDP. By plotting different levels of GDP against corresponding price levels, we can derive the AD curve, which shows the total quantity of goods and services demanded at various price levels.

What happens to the aggregate demand curve when there is an increase in investment spending?

An increase in investment spending shifts the aggregate demand (AD) curve to the right. This shift occurs because higher investment spending raises aggregate expenditures, leading to a higher equilibrium GDP at the same price level. In the AE model, this is represented by an upward shift in the AE curve. When we translate this to the AD curve, it means that at any given price level, more GDP is demanded. This rightward shift indicates an increase in the overall demand for goods and services in the economy, which can stimulate economic growth.

How do price levels affect aggregate expenditures in the AE model?

Price levels significantly impact aggregate expenditures in the AE model. When price levels rise, the purchasing power of money decreases, leading to lower consumption due to the wealth effect. Higher prices also increase interest rates, reducing investment spending through the interest rate effect. Additionally, higher domestic prices make exports less competitive, reducing net exports. Consequently, higher price levels lead to lower aggregate expenditures. Conversely, lower price levels increase consumption, investment, and net exports, resulting in higher aggregate expenditures. These changes in aggregate expenditures at different price levels help derive the aggregate demand curve.

What is the relationship between GDP and aggregate expenditures in the AE model?

In the aggregate expenditure (AE) model, GDP and aggregate expenditures are closely linked. Aggregate expenditures represent the total spending in the economy, which includes consumption, investment, government spending, and net exports. The equilibrium GDP is the level of GDP where total production (GDP) equals total spending (aggregate expenditures). When aggregate expenditures increase, it leads to a higher equilibrium GDP, indicating economic growth. Conversely, when aggregate expenditures decrease, the equilibrium GDP falls, signaling a contraction in the economy. This relationship is crucial for understanding how changes in spending affect overall economic output.

How do changes in price levels lead to shifts in the aggregate demand curve?

Changes in price levels lead to movements along the aggregate demand (AD) curve rather than shifts. When price levels rise, the quantity of goods and services demanded decreases, resulting in a movement up along the AD curve. Conversely, when price levels fall, the quantity demanded increases, leading to a movement down along the AD curve. However, shifts in the AD curve occur due to changes in non-price determinants, such as increases in investment spending, government spending, or changes in consumer confidence. These shifts indicate a change in the total quantity of goods and services demanded at every price level.