12.7 The Relationship of the AD Curve to the Aggregate Expenditures Model

What do the AE model and AD curve have in common on their horizontal axes?

Both measure real GDP.

What happens to the AE schedule when the price level rises?

It shifts downward, reducing equilibrium real GDP.

What are the three effects of a rising price level on aggregate expenditures?

1. Real wealth falls → less consumption

2. Interest rates rise → less investment

3. Net exports fall → fewer exports, more imports

How is the AD curve derived from the AE model?

By plotting (Price Level, Real GDP) pairs from the AE model — as price level increases, AE falls, and GDP decreases.

What do points 1′, 2′, and 3′ on the AD curve represent?

They show successively lower real GDPs at higher price levels, forming the downward-sloping AD curve.

What causes a shift of the AD curve when the price level is constant?

A change in a determinant of AD (like investment, consumption, or net exports).

What does an upward shift in the AE schedule indicate at constant price level?

An increase in aggregate demand and real GDP.

What amplifies the initial increase in spending in the AE model?

The multiplier effect, which causes successive rounds of consumption spending.

How is the horizontal shift of the AD curve calculated?

Shift of AD curve = initial change in spending x multiplier

In Figure 2b, what does the broken curve between AD₁ and AD₂ represent?

The initial increase in AD before the multiplier effect expands it to AD₂.

We can do so because the horizontal axes of both models measure….

Real GDP

What does the AE model show?

The relationship between total spending (AE) and real GDP at a given price level.

What does the AD curve show?

The relationship between the price level and the quantity of real GDP demanded.

What happens to the AE curve when the price level rises?

It shifts downward because consumption, investment, and net exports all decrease.

Why does consumption fall when the price level rises?

Because real wealth (purchasing power) falls — people feel poorer and spend less.

Why does investment fall when the price level rises?

Higher prices → more demand for money → interest rates rise → borrowing becomes more expensive.

Why do net exports fall when the price level rises?

Domestic goods become more expensive → exports fall, imports rise → net exports decline.

What happens to equilibrium GDP in the AE model when price level rises?

It decreases — lower AE means lower real output.

How does this change appear on the AD curve?

Each higher price level corresponds to a lower real GDP → creates the downward slope of the AD curve.

What causes a movement along the AD curve?

A change in the price level.

What causes a shift of the AD curve?

A change in spending components (C, I, G, NX) at a constant price level.