ECON 102 °Macroeconomic TheorySessions C and EWinter 2014, Musa Orak1WEEK 9 - Part IIRelated Readings: Chapter 12FROM IS-LM to AD-AS MODELWhen building the IS-LM model in previous handout and analyzing thee/ects of di/erent shocks, we had a very crucial assumption:±price level is²xed³(except that in the longer runadjustment was through changing prices). In this handout, by changing theprice levelP, we will derive the Aggregate Demand (AD) curve, which shows therelationship between the price level and the quantity of total output demanded.Just like a regular demand curve for a good/service is downward sloping, ADslopes downward as well.However, the underlying reasons are not the same.Demand curve for any good is downward sloping since the higher the price ofa good, the less people will demand. The downward slope of AD, on the otherhand, is more sophisitcated and follows from the interaction of goods and moneymarkets.Derivation of AD°Start with some random price levelP0. Let the equilibrium level of incomeobtained at this price through IS-LM beY0.°For anyP1< P0, we haveMP1>MP0and thus, this is a shift of moneysupply to the right. This, in turn will result in a lower interest rate for thesame level ofY. Therefore, for every level ofY, we have a lower level ofr. This is a shift of the LM curve to the right. This, as we know, resultsin a higherY(sayY1). Thus, we have another pair of price and output:(P1; Y1).°Similarly, for anyP2> P0, we haveMP2<MP0and thus, this is a shift ofLM curve to the left.This, as we know, results in a lowerY(sayY2).Thus, we have another pair of price and output: (P2; Y2).°Bringing all these together, we obtain a negative relationship betweenYandP, namelyAD.1Please e-mail me for errors and questions: [email protected]1

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