Question

Why does a reduction in aggregate demand in the actual economy reduce real output, rather than the price level? Why might a full-strength multiplier apply to a decrease in aggregate demand?

Short answer

The reduction in aggregate demand in the actual economy reduces real output rather than the price level because the prices are sticky.

A full-strength multiplier applies to a decrease in aggregate demand because prices are not flexible.

Step-by-step solution

Sticky price

The price is sticky in the short run, as it takes time for the economy to absorb the information and then act.A reduction in aggregate demand only reduces the output level but not the prices as the prices are inflexible, i.e., sticky prices.

Suppose it is assumed that prices are inflexible and the aggregate supply curve is horizontal, then a decrease in aggregate demand will not change the price but will reduce the output. The prices do not fall because of several reasons like wage contracts, minimum wage laws, employee morale, fear of price wars, and the “menu cost” notion.

Multiplier effect on aggregate demand

When there is no price movement or change, the multiplier effect could act to its full strength on the aggregate demand. Suppose the prices are flexible, then with the change in spending, i.e., reduction in government spending, will reduce the prices. Thus, some individuals will spend more in the economy, diminishing the multiplier effect.