Deriving aggregate demand

The aggregate expenditure model can be used to derive aggregate demand, and the aggregate demand curve.

Aggregate expenditure is composed of consumption and net injections, which include investment, government spending and net exports. Consumption is composed of autonomous consumption (a), plus induced consumption (bY), where 'b' is the marginal propensity to consume, and Y is the level of real income (real GDP).

The following table shows how aggregate expenditure varies with national income (GDP), assuming the price level remains constant.

AE schedule - hypothetical

From the schedule we can create a single aggregate expenditure line, as indicated by line E1. This represents total expenditure at the price level index of 100 [p=100]. We can use a simple index such as the Consumer Price Index (CPI) to represent the price level. From this we can see that aggregate expenditure equals total output, when output and expenditure equal 1000bn.

Deriving an AD curve - hypothetical

Deriving an aggregate demand curve

We can now derive one point on an aggregate demand curve - when the price level is p=100, GDP will equal 1000bn.

Deriving an AD curve - hypothetical

To derive more points on the aggregate demand curve we can simply remove the constraint of keeping the price level constant. Reducing the price level to 80 [p=80] will mean that aggregate expenditure will rise to E2, at 1500bn. The effect of this can be shown on the aggregate demand diagram.

Deriving an AD curve - hypothetical

If the price level is increased to 120 [p=120], aggregate expenditure will fall to E3, at 500bn. Hence, variations in the price level within the aggregate expenditure model can be used to derive an aggregate demand curve.

Aggregate demand

More on aggregate demand and the AD curve.

Fiscal policy

How can fiscal policy influence aggregate demand?

Monetary policy

Is monetary policy more effective at controlling inflation?