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Subject Business Economics

Paper No and Title 5, Macroeconomics Analysis and Policy

Module No and Title 16, Aggregate Demand (AD) Curve

Module Tag BSE_P5_M16

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Derivation of AD Curve
3.1 Aggregate Price Level and the IS-LM Model
3.2 The AD Curve
3.3. Shifts in the AD Curve
4. Equilibrium in AS-AD Framework
4.1 Short-run vs Long-run Equilibrium
4.2 Price Adjustments
5. Summary

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
____________________________________________________________________________________________________

1. Learning Outcomes
After studying this module, you shall be able to:

 Learn how to derive the Aggregate Demand (AD) Curve

 Understand the relation between aggregate price level and aggregate output
 Identify factors that cause shifts in the AD Curve
 Understand the concept of equilibrium in AS-AD framework
 Evaluate differences between the concepts of short run and long run equilibrium

2. Introduction
In the previous module we learnt about the Aggregate Supply (AS) curve, which essentially
captured the relation between aggregate price level and output, from the supply side. In that
module, we also referred to the Aggregate Demand (AD) curve that represented an inverse
relation between aggregate price and output levels. In this module we will now explain how to
derive the AD curve and understand why there is an inverse relation between price and output,
from the demand side. We will also learn about factors that affect the slope and cause shifts in the
AD curve. Thereafter we will cover the concept of equilibrium in the AS-AD framework which
was briefly introduced in the previous module. Here we will explore this relation in greater detail
and try to get a deeper understanding of these issues.

You may recall, in earlier modules, we used the IS-LM framework for analyzing macroeconomic
equilibrium in the short run, when prices were held constant. Now, the assumption of constant
prices is relaxed and we analyse how price adjustments take place and how they affect output and
macroeconomic equilibrium in the medium to long run.

The IS-LM analysis allowed us to study equilibrium in the goods and money markets, under the
assumption of constant prices. In this module we will use the AS-AD framework to study the
joint determination of equilibrium price and output levels.

In what follows first we turn to the IS-LM framework and examine how a change in prices affects
equilibrium in the goods and money markets. This gives us the essential tools to derive the AD
curve which is taken up next. Along with derivation of the AD relation we also examine factors
that affect the slope of this curve and factors that shift it. Thereafter we develop a deeper
understanding of equilibrium in the AS-AD model, which was briefly introduced in the previous
module (as we discussed the possible alternate slopes of the AS curve and their implications). In
particular we will distinguish between the concepts of short run and long run equilibria and try to
understand the role of price adjustments in achieving long run equilibrium at the natural level of
output.

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
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3. Derivation of AD Curve

3.1 Aggregate Price Level and the IS-LM Model

To understand the relation between aggregate price level and output, we will use the IS-LM
framework that was introduced in the previous modules. Can you recall, what was the role of
prices in the IS-LM framework? Prices figured in the LM curve relation, which represents money
market equilibrium. The LM curve is the locus of all interest rate – income combinations for
which the real demand for money is equal to real money supply.

Real money supply is essentially nominal money supply (M) divided by aggregate price level (P).
The real money supply is a parameter of the LM curve. Suppose the nominal supply of money is
given by M0 and price level is P0, so that real money supply corresponding to LM0 is (M0/P0).
Now if there is an increase in aggregate price level from P0 to P1, ceteris paribus, this reduces real
money supply to (M0/P1) and shifts the LM schedule to the left to LM1 (Figure 1). In contrast, a
decrease in price level (from P0 to P2) ceteris paribus, acts like an expansion in real money supply
and shifts the LM schedule to the right to LM2. Note in all these cases (i.e., for LM0, LM1 and
LM2) the nominal money supply is unchanged at M0.

What does this tell us about the relation between the aggregate price level and output? As price
increases, real money supply is reduced, the LM curve shifts to the left and equilibrium output is
lowered. Clearly, a decrease in price has the opposite effect; it acts like a monetary expansion and
raises equilibrium output. You should be able to see the reason for this, based on our previous
discussion on the IS-LM

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
____________________________________________________________________________________________________

3.2 The AD Curve

We are now ready to derive the Aggregate Demand relation. In Figure 1 above, note, initially
price level was P0 and equilibrium output was Y0. As price increased to P1, ceteris paribus, the
LM curve shifted from LM0 to LM1 and equilibrium in the goods and money market was
achieved at a lower level of output, Y1. As real money supply shrinks, with unchanged demand
for money, there is excess demand for money that leads to an increase in the interest rate. As the
interest rate increases, the interest elastic components of aggregate demand (investment and also
partly consumption expenditure) decrease, leading to a lower level of output at equilibrium.

Starting from P0, if the price level decreased to P2, given other things, the LM curve would shift
to the right and equilibrium output would be higher at Y2. You should be able to explain why this
happens.

We can represent the above price and equilibrium output combinations (P0, Y0), (P1, Y1), (P2, Y2),
graphically, with price measured along the vertical axis and output along the horizontal axis
(Figure 2). In this way, ceteris paribus, for each price level we can find the corresponding level of
output for which the goods and money markets are in equilibrium. The locus of all these points
gives the AD curve that represents the inverse relation between the aggregate price level and
GDP.

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
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Note along the AD curve, for each price level, the corresponding level of output represents a
point of short run equilibrium, i.e. equilibrium in the goods and money markets. Also, note that
for each price level along the AD curve, there is an associated rate of interest at which the goods
and money markets are in equilibrium and that can be read off the corresponding IS-LM curves
(i0, i1 and i2 in Figure 1 above).

From the above discussion you should clearly see the reason why the AD curve is downward
sloping. Can you also say what are some of the factors that would affect the slope of the AD
curve? When would the AD curve be very flat and when would it be very steep? Clearly, the
answer lies in the interest elasticity of the aggregate demand and money demand functions in the
IS-LM model. For instance, when aggregate demand is relatively interest inelastic (i.e. not very
responsive to changes in interest rate), a given change in price would be associated with relatively
small change in output and the AD curve would be steep. A flatter AD curve would be observed
when aggregate demand is fairly interest elastic and a given change in price has a fairly large
impact on output.

3.3 Shifts in the AD Curve

We will now discuss some of the factors that bring about a shift in the AD curve. Once again, you
should be able to grasp these concepts very clearly based on your previous understanding of the
IS-LM model.

Suppose there is a change in nominal money supply, holding all other factors (including the price
level) constant. Let us see first, how this affects output and interest rate in the IS-LM framework
and then we shall see its effects on the AD Curve. An increase in nominal money supply, from
M0 to M1, given prices, increases the real money supply and the LM curve shifts to the right. The
resulting excess supply of money lowers the rate of interest till money market equilibrium is
restored. At the lower interest rate, aggregate demand and hence the level of equilibrium output is
higher (Figure 3).

What does this mean for the position of the AD curve? After the increase in nominal money
supply, the level of output associated with price level P0 is no longer Y0, but it is now higher at
Y1. Clearly the AD Curve has shifted outward and (P0, Y1) lies on the new AD Curve, AD1 (lower
panel of Figure 3).

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
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BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
____________________________________________________________________________________________________

The AD Curve would also shift outwards (to the right) in response to a fiscal expansion. An
increase in government expenditure, ceteris paribus, would shift the IS curve to the right, from
IS0 to IS1 (upper panel of Figure 4). This would lead to higher output (Y1) and interest rates at the
given price level P0. This results in the AD curve shifting outwards to AD1 after the fiscal
expansion, as equilibrium output corresponding to P0 is now Y1 (Figure 4).

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
____________________________________________________________________________________________________

From the above discussion it should be clear to you that any increase in the exogenous
components of aggregate demand or in nominal money supply would shift the AD curve to the
right. While a contraction in aggregate demand or in nominal money supply would shift the AD
curve to the left.

4. Equilibrium in AS-AD Framework

In the previous module you learnt about the Aggregate Supply (AS) curve. We are now ready to
put the AS and AD curves together to develop a model for equilibrium price and output
determination. You have learnt that with totally rigid prices the AS curve is flat (the Keynesian
case) and with full price flexibility the AS curve is vertical (the Classical case). For our analysis
here we take the most general case and assume prices are neither completely rigid nor fully
flexible and consider the ‘intermediate’ range or an upward sloping AS curve.

In what follows first we study the determination of equilibrium price and output in the AS-AD
framework and examine the difference between the notions of short run vis a vis long run
equilibrium within this framework. Thereafter we try to understand the process of price
adjustment that induces a movement towards the equilibrium or ‘natural’ level of output in the
long run.

4.1 Short run vs Long run Equilibrium

The AS-AD framework allows for simultaneous determination of price and output as it brings
together the goods, money and labour markets. The position of the AD curve is determined by
variables like government expenditure, autonomous components of consumption and investment
demand, taxes and net exports (in an open economy). Points along the AS curve capture
equilibrium in the labour market, as it gives the price set by firms corresponding to the wage
demanded by workers corresponding to each level of output. The point of intersection of the AD
and AS curves gives the output and price at which the goods, money and labour markets are in
equilibrium in the short run.

You may note, there is no reason why the short run equilibrium should occur at the natural level
of output (Yn). Recall, from the previous module, the natural level of output is the full
employment level of output at which employment is at its natural level and the economy attains
the natural rate of unemployment. It is defined as the level of output at which price expectations
are fulfilled, so that expected and actual real wages are the same, with no further tendency for
change in real wages and hence output.

Suppose the equilibrium price-output combination in the short run is represented by (P0,
Y0).There is no reason Y0 should be equal to Yn; indeed Y0 may be greater than or less than Yn.
Recall from the discussion in the previous module that at Yn, P = Pe, i.e., actual price is equal to
expected price. This means, in the short run when output is equal to Y0, (and Y0 is not equal to
Yn) the corresponding price level P0 may be greater than or less than Pe.

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
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So what is the process that ensures a movement towards Yn, given that in the short run output is
not equal to the natural level? We discuss below the kind of price adjustments that are likely to
occur, inducing a movement of output towards Yn in the medium to long run.

4.2 Price Adjustments

Suppose the AD curve is AD0 and the AS curve is given by AS0 and the short run equilibrium
output is Y0, which is less than Yn (Figure 5). Clearly the actual price level, P0 is less than the
expected price level Pe. This would induce a downward revision in workers’ price expectations.

You may recall from our discussion in the previous module that the equation of the AS curve is Y
= Yn + β( P – Pe ). This means, changes in price expectations would affect the position of the AS
curve. As price expectations are revised downward, the AS curve would shift downwards; while a
rise in expected price level would shift the AS curve upwards.

At A (Figure 5), workers’ price expectations are not fulfilled. Since Y0<Yn, the actual price P0 is
less than the expected price level Pe, inducing workers to revise price expectations downwards.
As expected prices are adjusted downwards, the AS curve shifts downward along the AD curve
and actual prices are also lowered. Lower price expectations tend to lower workers’ demand for

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE
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wages that in turn, lead firms to lower prices; the assumption being that firms set prices as a
markup over wage costs. As prices are lowered, this leads to an increase in real money supply,
that in turn leads to lower interest rates and higher output. So the economy would move along the
demand curve AD towards B. At B output is equal to the natural level and price expectations are
fulfilled. As long as output is lower than Yn, actual prices remain above expected prices and this
process (downward revision of price expectations) continues with the AS curve shifting
downwards, till it reaches AS1 and output is equal to Yn and actual prices are equal to expected
prices P’e.

What happens when output is higher than Yn in the short run? In this case aggregate price level
would be higher than expected price, leading to upward revision of workers’ price expectations.
This would induce workers to bargain for higher wages and in turn lead to higher prices being set
by firms. With price expectations being revised upward, the AS curve would shift upwards. As it
moves up along the AD curve, higher prices would lower the real money supply, leading to a rise
in interest rates and thus to a contraction of output. The process continues till output falls back to
Yn, where once again actual prices and expected prices are the same. You should try to draw the
diagram for this case by yourself.

In this module we learnt how to derive the AD curve, we explored certain characteristics of
equilibrium output and prices in the AS-AD framework and learnt about the process of
adjustment towards the long run equilibrium level of output. In the following module, we shall
use the AS-AD framework and explore the impact of supply and demand shocks and learn about
the impact of monetary and fiscal policies on price and output.

5. Summary
 The AD curve captures the inverse relation between aggregate price and output.
 The AD curve represents all combinations of output and aggregate price level for which
the goods and money markets are in equilibrium.
 A change in aggregate price level affects output via a change in real money supply. This
is captured in movements along the AD curve.
 The AD curve shifts outward (inward) with an increase (decrease) in government
expenditure, net exports, nominal money supply and with a cut in taxes.
 The point of intersection of the AS and AD curve determines price and output at which
the goods, money and labour markets are in equilibrium.
 In the short run equilibrium output may not be equal to the natural level of output.
 In the medium to long run, as price expectations are revised and price adjustments induce
a movement towards the long run equilibrium or natural level of output.

BUSINESS PAPER No.: 5, MACROECONOMIC ANALYSIS AND

ECONOMICS POLICY
MODULE NO. : 16, AGGREGATE DEMAND (AD) CURVE