Question

1. Answer the following questions assuming known IS and LM curves.

1. Derive the associated aggregate demand (AD) curve.
2. Why does it have a negative slope?
3. What is the effect of an increase in taxes on the AD curve?
4. What is the effect of a decrease in real money balances on the AD curve?
     

Answer 1

1.

Below graphs derive the AD curve through equilibrium in IS and LM curve.

Initially, the equilibrium is at point E where IS and LM curves intersect each other. The goods and money market both are at equilibrium. The corresponding point in Panel 2 is point E where the output level is Y0 and the price level is P0.

Now, let say that the price level rises. This will lead a fall in the supply of real money balances = M/P. Consequently, the LM curve shifts left from LM to LM`. The new LM curve intersects the old LM curve at point E1 where the output level is Y1. The corresponding point in Panel2 is point E1 showing a higher price of P1.

Joining points E1 and E gives us the AD curve.

2.

AD curve slopes negative as it depicts a negative relationship between price and output/real GDP. At lower price levels, the real balances are higher holding money supply constant. A higher real balance leads to an increase in the output level

3.

An increase in taxes is like a Contractionary Fiscal Policy. Such an increase reduces the money in the hands of the public. Now, people will start demanding less quantity of goods. Overall, the Aggreagate Demand will fall and the AD curve shifts leftward.

4.

Real Money Balances = M/P

Holding M constant, a decrease in the real money balances implies a higher price level. The LM curve will shift to the left causing an upward movement along the AD curve and the output will fall

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