Along with the aggregate supply, AS, curve, the AD curve helps you figure out what the effect of policy will be on the price level and output. The AD curve represents the relationship between the price level and output that results from equilibrium in both the goods and financial markets. Recall that the IS and LM curves can be represented by the following equations:

  (Goods market) IS: Y = C(Y – T) + I(i) + G
  (Financial markets) LM: M/P = Y L(i)

The IS curve shown in the upper graph represents the relationship between i and Y that is consistent with equilibrium in the goods market. The LM curve shown in the upper graph represents the relationship between i and Y that is consistent with equilibrium in the financial markets.

  1. What level of output is consistent with equilibrium in both the goods market and the financial market when the price level is equal to P1 ?

Notice that equilibrium in the financial markets requires that the real money supply, defined as M/P, be equal to the demand for money.

  1. What happens to the real money supply, M/P, when the price level, P, rises ?
  2. How does an increase in the price level shift the LM curve ?
  3. What happens to the level of output consistent with equilibrium in the goods and financial markets when the price level rises ?

Move the price level up and down clicking on the Mark button to mark several points on the AD curve.

  1. What does the AD curve look like ?

Any other variable, besides the price level, that moves the IS curve or the LM curve, shifts the AD curve. Recall that a decrease in taxes shifts the IS curve to the right. Click on the Decrease T button. Move the price level handle up and down clicking on the Mark button at each price level.

  1. What happens to the AD curve when there is a decrease in taxes ?

The AD curve can be represented by the following equation including variables that shift the IS or LM curves:

AD relation: Y = Y(
M/P
,
G
,
T
)
 
+
,
+
,
–
  

The + and – signs underneath the equation shows how an increase in the real money supply, government spending, or taxes affects the position of the AD curve. An increase in G will shift the AD curve to the right. Let's put the AD relation together with the AS relation to see how monetary and fiscal policy affects Y and P. Go on to the next active graph.