Question

Use an IS curve and an MP curve to derive graphically the AD curve.

Short answer

The aggregate demand would show a negative relationship between price and output.

Step-by-step solution

Step 1. Introduction

An aggregate demand curve shows the total goods and services produced in an economy. It is comprised of investment, consumption expenditure, government spending, and net exports. The aggregate demand curve is generally a downward sloping line.

Step 2. Explanation

An investment-saving curve shows the different points at which the goods market is at equilibrium. The money preference curve shows the different points at which the money market is in equilibrium.

Suppose the nominal money supply is assumed to be constant. The price level rises which would further cause a decline in the supply of real money balances. As a result, the monetary policy curve or the LM curve would move to the left.

This leftward shift in the LM curve would cause the interest rate to increase. The increase in the price level would also cause a decline in the output level. The aggregate demand curve formed in this way would show an inverse relationship between price and output level. The different points on this AD curve would indicate the different combinations where both the goods market and the money market are in equilibrium.