Question

Is the following statement TRUE, FALSE or UNCERTAIN and explain why, with the appropriate illustration(s):

The IS/LM analytical framework is the theoretical foundation of the Aggregate Demand curve.

Answer 1

True. The IS/LM analytical framework is the theoretical foundation of the Aggregate Demand curve. The LM curve corresponds to M/P wherein P is the price level and money is the nominal supply of money. When the nominal money supply is held constant and when the value of P increases, the supply of real money balance(M/P) is going to fall. This will shift the LM curve to the left. A leftward shift in LM curve leads to increased interest rate and reduced income levels. This is consistent with the fact that as we move along the demand curve, an increase in price leads to reduced quantity demanded and is thus a reflection of reduced real income levels. Thus, the leftward/rightward movement of LM curve leads to reduced/increased level of income levels.

Now an increase/decrease in money supply with prices held constant leads to rightward/leftward shift in the LM curve. This further leads to a decrease/increase in interest rates and thus accordingly a change in income levels as well.

Any changes in the composition of IS curves(government expenditure, taxes, investment etc.) leads to rightward/leftward shift IS curve, which also gets translated into rightward/leftward shift of demand curve, showcasing that as the investment or government expenditure increases, the aggregate demand also increases.