Deriving the Aggregate Demand Curve

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Please note that change in price level affects the aggregate planned expenditure along with real GDP. We notice that aggregate demand curve is a downward slope. Let’s discuss the reason in detail:

  • Wealth effect
  • Substitution Effect
  • Wealth Effect:

Talking about the effect, when other influences are at rest and only price level changes to a higher level, the power of wealth which means power of purchasing the item is smaller than expected. Let’ understand the same with an example:

Consider a situation where you have 200 dollars in your account. With the level of the price is increased to 225, you will buy only fewer goods and would rather try to save a little extra money for some future expenditure. Therefore, we can say that when price level increases to a higher level, the aggregate planned expenditure is lower than expectation.

  • Substitution Effects

When the future price is gives as expected, and with sudden rise in current price level, one can notice that the current services, products and goods are comparatively more expensive as compared to the same goods, services and products in the future. Such a situation leads to a delay in the act of purchases which is known as inter temporal substitution. We can also conclude the same when  price level in U.S. increases, keeping other influences at rest, it results into the products, goods and services by U.S. more expensive than those from foreign countries. And therefore, such a situation gives a rise to more imports in U.S and lesser exports from U.S which is then entitled as international substitution.

And eventually when the rise in price level is realized, each effects of the same reduces the aggregate planned expenditure along with real GDP at every level which concludes that when price level rises, the curve of aggregate expenditure is moved downwards. The same is ture when price level is reduced. The curve of aggregate expenditure is moved upwards when price level falls down.

The figure illustrates the shifts in the curve AE. We can see the curve of aggregate expenditure is at AE0when price level is 110 intersecting the 450 line at another point at B. As discussed before, the expenditure at the equilibrium point is 13 trillion dollars. Therefore, the price level reaches a higher pint at 130, the curve of aggregate expenditure shifts to AE1 which is downward which in turn decreases the equilibrium to 12 trillion dollars. Similarly, when price level drops to 90, the curve of aggregate expenditure is moved upwards at AE2 intersecting the 450 line at another point C and the equilibrium increase to 14 trillion dollars.

From the figure, we can analyze that when there is change is price level, the curve of aggregate expenditure changes along with equilibrium keeping other influences at rest. But along with the same, we notice that change in price level creates a movement alongside the curve of aggregate demand.

The next figure illustrates the movement of the curve of aggregate demand. When price level is at 110, we can notice point B on the AD curve which states that the aggregate quantity of services, products and goods in demand is 13 trillion dollars. Similarly, when price level is at 130, the curve of aggregate demand is reduces to 12 trillion dollars. In addition to the same, when price level drops to 90, the line intersects at point C, which means that the quantity in demand of aggregate service, goods and products increases to 14 trillion dollars.

Hence, we can state that every point on the curve of aggregate demand reacts to the equilibrium point in expenditure. The equilibrium points A, B and C of expenditure in first figure corresponds to the equilibrium points A, B and C of curve of aggregate demand in the second figure.

 

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