Question

Please fully explain what happens to the multiplier when the aggregate demand is increased in Short Run; and explain what happens whens to the multiplier when the aggregate demand is increased in Long Run. Use the graphs available on your slides and explain step by step.

Answer 1

In Macroeconomics, specifically in the goods market, aggregate demand(AD) represents or denotes the overall or total demand for goods and services in the economy which constitutes of several main components or factors. In this regard, some of the factors or components of AD include aggregate consumption expenditure or spending, aggregate investment spending or expenditure, aggregate government expenditure or spending, and the total net export in the case of open economy. Now, aggregate consumption expenditure or spending is the total or overall spending or expenditure by consumers or households on all the goods and services in the economy which ideally depends on the disposable income of the consumers or households and the interest rate set by the Central Bank in the money or loanable funds market. The aggregate investment expenditure by firms and companies is mainly contingent on the interest rate set by the Central Bank or the cost of financial borrowing or loan in the loanable funds or money market. The aggregate government expenditure or spending constitutes the overall or total spending or the expenditure by the government on various infrastructural, developmental, public welfare projects and undertakings in the economy which is mainly financed or liquidated by various public and administrative taxes and other government borrowings from other sources. The net export basically shows the difference between in the overall or total export level of goods and services and the total import level of goods and services in the international market by any country.

Now, in general, an increase in the AD denotes an increase in any of the four main components or factors of AD as explained previously due to favorable or suitable fluctuations or modifications of the factors or attributes affecting them. In the short run, an increase in AD would essentially lead to an increase in the price level of goods and services and the real output or income in the goods market or the economy, holding the short-run aggregate supply(SRAS) as constant which is the overall or total production level of goods and services in the goods market or the economy. An initial increase in the real income in the goods market or the economy would imply an increase in the real purchasing power of the consumers or households, again considering all else constant such as the price of the goods and services. Therefore, an increase in the real purchasing power of the consumers or households would further induce higher spending or expenditure by the consumers or households on goods and services which would lead to an increase in the overall consumption expenditure or spending in the economy. This would lead to a secondary increase in the AD in the short run and a further rise in the real output or income level in the goods market or the economy, again holding SRAS as constant. This is usually viewed or described as the multiplier effect of an increase in AD in the economy and the actual impact or magnitude of the multiplier effect, in this case, would depend on the marginal propensity to consume(mpc) and the marginal propensity to save(mps) by the individual consumers or households in the economy. The higher mpc essentially implies that consumers or households are likely to spend the additional income that they obtain signifying a relatively higher multiplier effect in the economy under such a scenario and vise versa. In general, the marginal propensities indicate how the additional income available to the households or consumers due to an increase in the real income would be allocated, which can either be spent or expended on the consumption of goods and services or saved.

On the other hand, an increase in the AD in the long-run alone cannot have any impact on the real output or income considering that long-run aggregate supply or LRAS is vertical or does not change accordingly with the change in the price level of goods and services in the goods market or the economy as the SRAS. Hence, unlike the short-run, an increase in AD can only lead to a higher real output or income if the LRAS also increases. Thus, even if any of the four components or determinants of the AD increases, the real income would not increase unless the LRAS changes accordingly, and the multiplier effect would not prevail as is the case in the short run. The long-run stability of the AS would offset any multiplier effect of an increase in the real income or output due to a rise in the AD in the long-run. In the short-run an increase in the AD would cause inflationary effects in the goods market or the economy implying an increase in the price level of goods and services, again considering SRAS as unchanged. This would eventually reduce the real income or purchasing power of the consumers or households and the prices of factors or inputs or production and productive resources employed by firms and companies in the long-run. Therefore, the firms and companies would adjust their production level of goods and services accordingly reducing the AS in the long-run and restoring the real GDP or income at its pre-existing position or level thereby eliminating the immediate multiplier effect of an increase in the AD in the short-run. Hence, in the long-run the real GDP or income does not change due to the short-run fluctuations of AD and the multiplier effect of any short-run positive or negative shock on AD would be offset.