Relations between the multiplier & price level

Aggregate Expenditure & Demand with Price Level

Price levels can affect how the aggregate expenditure changes, and how the aggregate demand moves.

Recall that the aggregate demand curve is downward sloping for two reasons:

1. Wealth Effect: the higher the price level, the lower your purchasing power is. Therefore, people would spend less money on goods overall and save more.


2. Substitution Effect: The higher the price level of US goods, the less exports they will be, and the more imports we will have (due to cheaper prices on foreign foods).

Therefore, price level does two things:

1. when price level rises, these effects will decrease aggregate expenditure, causing it to shift downwards .


2. when price level falls, these effects will increase aggregate expenditure, causing it to shift upwards.

However, aggregate demand does not shift, it only moves along the curve.

Aggregate Expenditure & Demand without Price Level

Other influences (that are not price level) can also affect how aggregate expenditure and aggregate demand change.

Suppose we have our $AE$ curve and the equilibrium expenditure is at 10.5 trillion.


Let’s say that there is a $0.5 trillion increase in investment, causing the aggregate expenditure to shift up.


A new equilibrium expenditure has been achieved.

However, since real GDP has increased without a change in the price level, the aggregate demand curve shifts to the right.


Note: the aggregate demand shifts by how much the multiplier is.

$Shift\; in\; AD\; Curve = \Delta autonomous\; expenditure \times Multiplier$

Changes in the Aggregate Demand

Though we talked about aggregate demand, we also need to add in aggregate supply so that we can find the equilibrium real GDP and price level.

To do so, we need to add two-time frames: short-run & long-run.

Short Run: Suppose we have our $AE$ curve and the equilibrium expenditure is at 10.5 trillion.


Let’s say that there is a $0.5 trillion increase in investment, causing the aggregate expenditure to shift up.


A new equilibrium expenditure has been achieved.

However, since real GDP has increased without a change in the price level, the aggregate demand curve shifts to the right.


Eventually, price level must rise so that aggregate demand and supply can reach equilibrium.


Since price level has risen, the aggregate expenditure decreases and shifts downward, giving a new equilibrium expenditure.


Long Run: Suppose we have the exact same scenario as the short-run, but now we add the long-run aggregate supply curve.


Notice that real GDP > potential GDP, so we are in an inflationary gap and at above full employment. At high price levels, workers want more money, causing the supply curve to decrease. This shifts to the supply curve to the left.


We see that the new equilibrium increases the price level, which decreases aggregate expenditure down back to the original (AE2 to AE0)


Note: In the long run, the multiplier is equal to 1 because we went back to the original $AE$ curve.