Explain the relationship between the aggregate expenditures model in graph (A) below and the aggregate demand–aggregate supply model in graph (B) below. In other words, explain how points 1, 2, and 3 are related to points 1’, 2’, and 3’.
Through the real-balances, interest-rate, and foreign purchases effects, the consumption, investment, and net exports schedules and therefore the aggregate expenditures schedule will rise when the price level declines and fall when the price level increases. If the aggregate expenditure schedule is at (C + Ig + Xn)2 when the price level is P2, we can combine that price level and the equilibrium output, GDP2, to determine one point (2’) on the aggregate demand curve. A lower price level such as P1 shifts aggregate expenditures to (C + Ig + Xn)1, providing us with point 1’ on the aggregate demand curve. Similarly, a higher price level at P3 shifts aggregate expenditures down to (C + Ig + Xn)3 so P3 and GDP3 yield another point on the aggregate demand curve at 3’.
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