Standard Keynesian analysis is based on the assumption that the price level is constant or an exogenous variable of the model. Aggregate market analysis, in contrast, includes the price level as an endogenous variable. In Keynesian analysis aggregate production is assumed to rise or fall to match any changes in aggregate expenditures. In aggregate market analysis aggregate production is more realistically subject to constraints which are reflected in a price level changes.

The Aggregate Market

The Aggregate Market

Key to this present discussion, any shock to the aggregate market, especially caused by a shift of the aggregate demand curve, results in a change in the price level. Moreover, this price level change will then cause a movement along the aggregate demand curve as equilibrium is restored.

With this in mind, suppose that there is an increase in aggregate demand, such as that caused by a $1 trillion increase in investment expenditures. This, of course, causes a rightward shift of the aggregate demand curve and results in a new equilibrium. Click the [AD Increase] button to illustrate this shift.

The new equilibrium is achieved at a higher price level, P1, and a larger level of aggregate production, $13 trillion, given by the intersection of the new aggregate demand curve and the original short-run aggregate supply curve.

A Keynesian Comparison

• Consider the rightward shift of the aggregate demand curve. The standard Keynesian multiplier analysis assumes that the price level remains unchanged. As such, the initial horizontal shift of the aggregate demand curve indicates the Keynesian multiplier. Click the [Keynesian Multiplier] button to illustrate.


• The horizontal shift of the aggregate demand curve, measured at the original price level, Po, is the change in aggregate production resulting from the Keynesian multiplier. This is indicated by the movement from point A to point C. This level of aggregate production is $16 trillion, a $4 trillion increase resulting from a $1 trillion investment injection and a multiplier of 4.


• However, the aggregate market analysis indicates that the price level does not remain constant at Po, but instead rises to P1. This increase in the price level leads to the real-balance, interest-rate, and net-export effects, which cause a movement along the aggregate demand curve from point C to point B.


• The higher price level, as such, dampens the original Keynesian multiplier process. Rather than a multiplier of 4, which triggers the $4 trillion change that achieves $16 trillion in aggregate production, the price-adjusted multiplier is only 1 in this case. At the short-run equilibrium intersection point B, the change in aggregate production is only $1 trillion, and the equilibrium level of aggregate production is $13 trillion.