32A Appendix The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model This appendix presumes knowledge of the aggregate expenditures model discussed in chapter 32. The aggregate demand curve is derived from the aggregate expenditures model by allowing the price level to change and observing the effect on the aggregate expenditures schedule and thus on equilibrium GDP. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Derivation of Aggregate Demand AE1 (at P1 ) AE2 (at P2 ) 1 AE3 (at P3 ) 2 Aggregate Expenditures (billions of dollars) 3 LO1 LO1 LO1 45° In Figure 1 we are deriving the aggregate demand curve from the aggregate expenditures model. Both models measure real GDP on the horizontal axis. Suppose the initial price level is P1 and aggregate expenditures is AE1. Equilibrium real domestic output is Q1. There will be a corresponding point on the aggregate demand curve (Point 1). If price rises to P2, aggregate expenditures will fall to AE2 because purchasing power of wealth falls, interest rates may rise, and net exports fall. Then new equilibrium is at Q2. That generates a point (Point 2) up and to the left of Point 1. If price rises to P3, real asset balance value falls, interest rates rise again, net exports fall and new equilibrium is at Q3. This generates a point (Point 3). Technically, the aggregate demand curve is found by drawing a line (or curve) through Points 1, 2, and 3. P3 3 Price Level P2 2 1 P1 AD Q3 Q2 Q1 Real Domestic Product, GDP LO5

Aggregate Demand Shifts Price Level Aggregate Expenditures Real Domestic Product, GDP 45° AE2 (at P1 ) AE1 (at P1 ) Figure 2 shows shifts of the aggregate expenditures schedule and of the aggregate demand curve. When there is a change in one of the determinants of consumption, investment, or net exports, there will be a change in the aggregate expenditures as well. The change in aggregate expenditures is multiplied and aggregate demand shifts by more than the initial change in spending. The text illustrates the multiplier effect of a change in investment spending. Shift of AD curve = initial change in spending x multiplier. P1 AD2 AD1 Q1 Q2 LO5