IBonomicsKeynesian Multiplier Effect – Shifts in Aggregate DemandHL
MacroeconomicsThis diagram shows how an initial increase in aggregate demand leads to a multiplied increase in national output (real GDP) and price level within the Keynesian framework.
Curves and elements
- ad
- AD: The initial aggregate demand curve before the multiplier effect.
- ad1
- AD1: The result of the first round of increased spending.
- ad2
- AD2: Final impact of the multiplier, showing further outward shift in AD.
- lras
- LRAS: The Keynesian long-run aggregate supply curve, which becomes vertical at full employment.
- y1
- Y1: Initial equilibrium output before any AD increase.
- y2
- Y2: Intermediate level of real GDP after partial multiplier effect.
- y3
- Y3: Final level of output after full multiplier effect, near or at full employment.
- pl1
- PL1: Initial price level.
- pl2
- PL2: Price level after moderate increase in AD.
- pl3
- PL3: Price level after strong increase in AD, reflecting inflationary pressure.
- arrows
- Black arrows: Indicate the outward shifts of AD curves from AD → AD1 → AD2.
Key explanations
- 1
In the Keynesian model, an initial increase in aggregate demand (AD → AD1) leads to a larger overall increase in real GDP due to the multiplier effect.
- 2
Further increases (AD1 → AD2) continue this expansion, but as the economy approaches full capacity (Y3), increases in AD result more in inflation (PL1 → PL3) than output growth.
- 3
The curved shape of the LRAS illustrates that the economy initially has spare capacity (horizontal portion), then experiences increasing opportunity cost (upward-sloping segment), and finally reaches full employment (vertical segment).
- 4
The multiplier effect is stronger when the economy is below full employment, leading to large increases in output with only mild inflationary pressure.
- 5
At Y3, the economy is at full employment, and any further increase in AD will lead primarily to inflation, not output growth.
Example exam question
Using the Keynesian AD/AS diagram, explain how the multiplier effect leads to changes in output and the price level.
Show example answer
The diagram shows how an initial increase in AD (AD to AD1) leads to a larger rise in GDP (Y1 to Y2) due to the multiplier effect. Because the economy has spare capacity, output increases without much inflation. However, as AD increases further (AD1 to AD2), the economy nears full employment (Y3), causing a steeper rise in the price level (PL2 to PL3).
