Question

Derive the AD fn from the AE fn and explain the differences/similarities between the two.

Answer 1

AGGREGATE DEMAND

Aggregate demand is an economic measurement of the total amount of demand for all finished goods and services produced in an economy. Aggregate demand is expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.

In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand

The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. A diagramatic representation of aggregate demand curve is given below

The vertical axis represents the price level of all final goods and services. The aggregate price level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real quantity of all goods and services purchased as measured by the level of real GDP. Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP.

Reasons for a downward‐sloping aggregate demand curve.

Wealth effect : The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before.

Interest rate effect : As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.

Net exports effect :As the domestic price level rises, foreign‐made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic‐made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports ‐ imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.

AGGREGATE EXPENDITURE

Aggregate Expenditure (AE) is the total desired or planned expenditure on goods and services in the economy, that is: AE = C + I + G + NX . Using the expenditure approach, we have seen that GDP was equal to: Y = C + I + G + NX.  GDP is equal to the actual expenditure on domestically produced goods and services . Therefore, actual expenditure on domestically produced goods and services is equal to income (Y) since GDP is equal to income by assumption . The Aggregate Expenditure function indicates the desired level of expenditure at each level of income (Y) .

The Aggregate Expenditure function is an increasing function of Y . Therefore, there must be a level of income at which desired aggregate expenditure (AE) is equal to actual aggregate expenditure (GDP = Y). This level of income at which Y = AE is the equilibrium level of output or income (Y*)  At Y* the goods market is in equilibrium If Y ≠ AE, then the economy is not in equilibrium . If Y > AE  excess supply in the goods market . If Y < AE  excess demand in the goods market . Since P is assumed fixed, then the implicit assumption is that aggregate expenditure determines the amount of goods produced in the economy . That is, Y must change in order to restore equilibrium in the economy . Y must increase to eliminate an excess demand . Y must decrease to eliminate an excess supply.

Aggregate expenditure and aggregate demand are macroeconomic concepts that estimate two variants of the same value: national income.

In the sub-specialty deemed national income accounting, the market value of all products and services is summed to estimate gross national income, the aggregate wealth produced by the country.

Both aggregate expenditure and aggregate demand take consumption, investment, government outlays, and net factor income from abroad as the basic components of economic demand. When the economy is in equilibrium, spending levels on consumption, investment, government outlays, and net factor income from abroad equate to total effective demand and, therefore, the value of all goods and services supplied by the economy.

Though both AE and AD are calculated by summing the same variables- consumption spending, government expenditures, investment spending and net exports, there are some basic differences-

1. AE shows the relationship between total spending (dependent on income) in the economy and the level of real GDP produced holding the price level constant. Of all the components of AE, consumption spending is the only one which depends on income. So, shifts in income cause a movement along the AE curve.
2. AD shows the relationship between price level and the level of real GDP produced, holding all else constant, including income. So, there is a movement along the curve when the price level changes.

Notice this essential difference:

• When the price level changes, there is a movement along the AD curve but a leftward or rightward shift in the AE curve
• When the income level changes, there is a movement along the AE curve but a leftward or rightward shift in the AD curve.

AD is the demand of all goods and services in a market at different price levels (or other curve shifters). Similarly, AE is the aggregate spending that occurs in a market. But this time, we can use it’s definition to compute the GDP.  AD is how much the people in a market demand (or want to buy) goods and services. On the other hand, AE is actually how much they end up spending.

We can use the aggregate expenditures model to gain greater insight into the aggregate demand curve. In this section we shall see how to derive the aggregate demand curve from the aggregate expenditures model. We shall also see how to apply the analysis of multiplier effects in the aggregate expenditures model to the aggregate demand–aggregate supply model.

An aggregate expenditures curve assumes a fixed price level. If the price level were to change, the levels of consumption, investment, and net exports would all change, producing a new aggregate expenditures curve and a new equilibrium solution in the aggregate expenditures model.

Panel(a) "From Aggregate Expenditures to Aggregate Demand" shows three possible aggregate expenditures curves for three different price levels. For example, the aggregate expenditures curve labeled AE_P=1.0 is the aggregate expenditures curve for an economy with a price level of 1.0. Since that aggregate expenditures curve crosses the 45-degree line at $6,000 billion, equilibrium real GDP is $6,000 billion at that price level. At a lower price level, aggregate expenditures would rise because of the wealth effect, the interest rate effect, and the international trade effect. Assume that at every level of real GDP, a reduction in the price level to 0.5 would boost aggregate expenditures by $2,000 billion to AE_{P = 0.5}, and an increase in the price level from 1.0 to 1.5 would reduce aggregate expenditures by $2,000 billion. The aggregate expenditures curve for a price level of 1.5 is shown as AE_P=1.5. There is a different aggregate expenditures curve, and a different level of equilibrium real GDP, for each of these three price levels. A price level of 1.5 produces equilibrium at point A, a price level of 1.0 does so at point B, and a price level of 0.5 does so at point C. More generally, there will be a different level of equilibrium real GDP for every price level; the higher the price level, the lower the equilibrium value of real GDP.

Because there is a different aggregate expenditures curve for each price level, there is a different equilibrium real GDP for each price level. Panel (a) shows aggregate expenditures curves for three different price levels. Panel (b) shows that the aggregate demand curve, which shows the quantity of goods and services demanded at each price level, can thus be derived from the aggregate expenditures model. The aggregate expenditures curve for a price level of 1.0, for example, intersects the 45-degree line in Panel (a) at point B, producing an equilibrium real GDP of $6,000 billion. We can thus plot point B′ on the aggregate demand curve in Panel (b), which shows that at a price level of 1.0, a real GDP of $6,000 billion is demanded.

Panel (b) "From Aggregate Expenditures to Aggregate Demand" shows how an aggregate demand curve can be derived from the aggregate expenditures curves for different price levels. The equilibrium real GDP associated with each price level in the aggregate expenditures model is plotted as a point showing the price level and the quantity of goods and services demanded (measured as real GDP). At a price level of 1.0, for example, the equilibrium level of real GDP in the aggregate expenditures model in Panel (a) is $6,000 billion at point B. That means $6,000 billion worth of goods and services is demanded; point B' on the aggregate demand curve in Panel (b) corresponds to a real GDP demanded of $6,000 billion and a price level of 1.0. At a price level of 0.5 the equilibrium GDP demanded is $10,000 billion at point C', and at a price level of 1.5 the equilibrium real GDP demanded is $2,000 billion at point A'. The aggregate demand curve thus shows the equilibrium real GDP from the aggregate expenditures model at each price level.

The lowest price level, P₁, corresponds to the highest AE curve, AE_{P = P1}, as shown. This suggests a downward-sloping aggregate demand curve. Points A, B, and C on the AE curve correspond to points A′, B′, and C′ on the AD curve, respectively.