In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GDP the AS-AD model must be used. The AD curve is related to the AE curve.

The Aggregate Expenditure Curve and the Aggregate Demand Curve

The AE curve is the relationship between aggregate planned expenditures and real GDP, all other influences (such as the price level) remaining the same. The AD curve is the relationship between the aggregate quantity of goods and services demanded and the price level. When the price level changes, the AE curve shifts and there is a movement along the AD curve.

A change in the price level has two effects on consumption expenditure:

· Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures.

· Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect). It also makes U.S. goods and services more expensive relative to imports (an international substitution effect).

The wealth effect and the substitution effects show that a rise in the price level decreases consumption expenditure. So, as shown in the figure below to the left, a rise in the price level from 120 to 140 decreases aggregate planned expenditure and shifts the AE curve downward from AE0 to AE1. In the figure, equilibrium expenditure decreases to $11 trillion.

The diagram to the right, below, shows that when the price level rises from 120 to 140, there is a movement along the AD curve from point a to point b. The aggregate quantity of real GDP demanded decreases from $13 trillion (which is the initial equilibrium expenditure in the AE diagram to the left) to $11 trillion (which is the new equilibrium expenditure along AE1 in the AE diagram to the left).

If the AE curve shifts for any reason other than a change in the price level, then the AD curve also shifts. For instance, an increase in autonomous expenditures shifts the AE curve upward and increases equilibrium expenditure by a multiplied amount. In this case, the AD curve shifts rightward and the amount of the rightward shift is equal to the increase in equilibrium expenditure.

In the figure to the right, autonomous expenditure increases so that the AD curve shifts rightward. The multiplied increase in autonomous expenditure has created a $2 trillion increase in equilibrium expenditure, so the AD curve shifts rightward by $2 trillion (which equals the length of the double headed arrow) from AD0 to AD1.

Equilibrium Real GDP and the Price Level

Aggregate demand and short-run aggregate supply determine the equilibrium price level and real GDP.

In the short run:

· An increase in aggregate demand raises the price level and increases real GDP. In the figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $13 trillion to $14 trillion.

· The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure. In terms of the AE curve, the increase in the price level shifts the AE curve downward.

· Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account. The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run.

In the long run:

· Real GDP exceeds potential GDP and employment exceeds full employment. So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward. The economy moves along the AD curve so that the price level rises and real GDP decreases.

· In the figure above, the economy moves along AD1 from point b to point c. (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $14 trillion back to potential GDP of $13 trillion.

· The further increase in the price level further decreases aggregate planned expenditure. In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level. As a result, the long-run multiplier is equal to zero.