AD-AS Model - Aggregate Demand Curve

Aggregate Demand Curve

The AD curve is defined by the IS-LM equilibrium income at different potential price levels. The Aggregate demand curve AD, which is downward sloping, is derived from the IS – LM model.

It shows the combinations of the price level and level of the output at which the goods and assets markets are simultaneously in equilibrium. The above figure showing IS and LM curves, where LM curve shifts downward to the right to LM’ and thus shifting the new equilibrium to E’ where both goods and money market gets cleared. Now, the new output level Y’ correspond to the lower price level P’. Thus a reduction in price, which is shown in the figure, leads to an increase in the equilibrium and spending.

The equation for the AD curve in general terms is:

where Y is real GDP, M is the nominal money supply, P is the price level, G is real government spending, T is an exogenous component of real taxes levied, and Z₁ is a vector of other exogenous variables that affect the location of the IS curve (exogenous influences on any component of spending) or the LM curve (exogenous influences on money demand). The real money supply has a positive effect on aggregate demand, as does real government spending (meaning that when the independent variable changes in one direction, aggregate demand changes in the same direction); the exogenous component of taxes has a negative effect on it.