Question

Answer the following questions assuming known IS and LM curves.

Derive the associated aggregate demand (AD) curve.

Why does it have a negative slope?

What is the effect of an increase in government spending on the AD curve?
  

What is the effect of an increase in real money balances on the AD curve?

Answer 1

For deriving AD curve we assume the following

M or nominal money is constant

And only P varies.

So if the price increases , we see the real money balances(M/P) will fall. So the second graph is the resultant of AD CURVE.

AD curve shows the relation between the aggregate prices and national income or total output.

So when the price is less the quantity or output is more and vice versa. There exists an inverse relation and hence it has a negative slope.

here the only change is in the price level and M is the constant which reduces the real money balanxes and hence we derive the Ad curve. The prices can also increase and LM curve shifts to left and when price reduces LM CURVE shifts to right.

When the government expenditure increases , we see a shift in the IS curve since IS= C+I+G+NX where C is consumption ,I is investment, G is government expenditure and NX is net exports.

So increase in G will shift IS to right and hence the AD curve shifts to right. Aggregate demand is increasing as the government is spending on people.

the increasd in government spending shifts IS curve to right

When the real money balances or M/P would increase, it will result in a shift of LM CURVE towards Right.

But the AD curve would not shift and the movement would be along the AD itself. This would be in the case when the price level reduces and LM curve will shift to right. It is shown in the first figure where the LM 1 shifts to LM2 AND the result i shown in AD by movement along the curve.

If the M is not constant, and it changes so when M increases,real Money balances will increase and this would shift the AD because this time the change is in M and not P.

When the change is in P there is movement along the curve and when change in M AD curve shifts to right.