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Intended Learning Outcomes
– Understand AD
– Derive AD graphically and algebraically
– Analyze the slope and position of the AD
curve
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Session outline
• Derivation of AD Curve
• Graphical and Algebraic treatment of AD curve
• Slope of AD curve
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Aggregate Demand (AD)
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 The aggregate demand curve shows the combinations of the
price level and the level of output at which the goods and
money markets are simultaneously in equilibrium.
The AD curve is downward sloping because higher prices
reduce the value of money supply , which reduces the demand
for output.
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 As a first step towards making the price level an endogenous
variable, we develop a new tool called the aggregate demand, or
AD curve.
 We are still treating the price level as exogenous, but we are
allowing it to take on alternative exogenously determined values.
 Each value gives rise to a specific LM curve, and hence to a
specific IS-LM equilibrium.
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DERIVATION OF THE AD CURVE:
A GRAPHICAL TREATMENT OF THE AD CURVE
 The AD curve is drawn by plotting each equilibrium level of
national income, Y, against the value of the price level, P, that
gave rise to it. Hence, the AD curve plots all combinations of the
price level and national income that yield equilibrium in the
goods and the asset markets - i.e., the IS-LM equilibrium.
 With the LM curve, the exogenous variables are the real money
supply (M/P), and the constant money demand curve.
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 Since we are going to study how the equilibrium value of Y
changes as the price level changes, we can no longer hold P
constant. Instead, P will be allowed to vary while the nominal
money supply is held constant at some value M0.
 This changes the real money supply and shifts the LM curve.
 Changing the price level, shifts the LM curve and produces a
new equilibrium level of national income. Plotting that national
income against the given price level, yields one point on the AD
curve.
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LM2 (M0/P2)
LM1(M0/P1)
LM0 (M0/P0)
Interest Rate
E2
i2
i1
E1
E0
i0
IS0
0
Y2
Price Level
P2
Y1
Y0
National Income
c
b
P1
a
Po
AD
0
Y2
Y1
Y0
National Income
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DERIVATION OF THE AD CURVE:
AN ALGEBRAIC TREATMENT OF THE AD CURVE
• We can derive the algebraic version of the AD curve by using
the equations of the IS-LM model
• Y0 = γA + β(M0/P) ---------------------------(1)
• Where:
 

1 

G
k G b 

h 
b G

h  k Gb 
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We can focus more explicitly on the price level by simply solving
equation (1) for the price level. Rearranging the terms of the resulting
equation we have
------------------------------ (2)
 We can note that, given output and exogenous spending, prices are
proportionate to the money stock.
 Thus changes in M0 translate into proportionate changes in P.
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The Slope of the AD Curve
 The slope of the AD curve reflects the extent to which a
change in real balances, changes the equilibrium level of
spending.
– An increase in real balances leads to a larger increase in
equilibrium income and spending, the smaller the interest
responsiveness of money demand and the higher the
interest responsiveness of investment demand.
– An increase in real balances leads to a larger increase in
equilibrium income and spending, the larger the
multiplier and the smaller the income response of money
demand.
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– Because the slope of the AD curve is determined by the
effect of a change in real balances on equilibrium spending
and output, the same factors that determine the effects of a
change in the stock of money on equilibrium output and
spending also determine the slope of the AD curve.
– The curve is flatter the smaller the interest responsiveness of
the demand for money and the larger the interest
responsiveness of investment demand.
– The AD curve is flatter the larger the multiplier and the
smaller the income responsiveness of the demand for money.
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Price level
P0
E
P1
E2
E1
AD1
AD2
0
Real national income
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Shifts in the AD Curve

The position of the AD curve depends on autonomous
expenditure and monetary conditions in terms of the demand
for, and supply of, money.
1. A Change in Autonomous Expenditure:
A rise in autonomous expenditure shifts the aggregate
expenditure function upwards, and raises the equilibrium
level of national income that is associated with any given
interest rate and price level.
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Interest Rate
IS0
i1
LM0
(M/P0)
E1
E0
i0
0
Price level
IS1
Y1
Y0
z
P0
Real national income
x
AD0
0
Y0
This would cause a
rise in national
income (economic
growth) and lead to
a fall in
unemployment (and
vice versa)
Y1
AD
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Real national income
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2. A Change In Nominal Money Supply:

An increase in the nominal money supply shifts the LM curve
to the right.

This lowers the interest rate, and increases equilibrium national
income through the operation of the monetary transmission
mechanism.

Plotting the new equilibrium level of national income against
the existing price level, shows that the aggregate demand curve
has shifted rightwards.
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Interest Rate
LM0 (M0/P0)
IS0
E0
i1
LM1 (M1/P0)
E1
i0
0
Y0
Y1
Real national income
P0
AD1
AD0
0
Y0
Y1
Real national income
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