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The AD relation

The AD relation basically shows us how the price level affects output. It is downward sloping, which tells us when prices are higher, output is lower, when prices are lower, output his higher.

This process can basically be explained through the ISLM model, particularly because the price changes take effect through the LM curve.

Start by going back to the model of money supply and money demand.

We analyse the effect of prices, through the vertical money supply curve. Remember that we are really thinking of money supply and money demand in terms of real money balances, \frac{M}{P}. The Central Bank controls the amount of money in the economy, M, but to know what this is worth in terms of real money balances, you have to take into account the price level as well. When prices rise, (M/P) falls so the vertical money supply curve shifts to the left. When prices fall, (M/P) rises so the vertical money supply curve shifts to the right.

If the amount of money in the economy, M, is changing at the same time as prices, then the directon the money supply curve will shift depends on what happens to the overall value of (M/P), for instance if M is rising, but P is rising faster, then (M/P) will be getting smaller, so the supply curve goes left.

Lets think of the effect of higher prices on output. P rising means the money supply curve shifts left (assuming M is fixed or P is rising faster than M). Shifting the money supply curve left while money demand is held constant, means the equilibrium interest rate will be higher.

The LM curve tells us how output affects the interest rate that will bring the money market into equilibrium. If the money supply curve has shifted left in the money supply/money demand diagram, this means that we have a higher equilibrium interest rate full stop, ie at all levels of output the equilibrium interest rate will be higher than it was before. This is basically shifting up the LM curve.

So an increase in prices means a rise in the equilibrium interest rate at all levels of output (as shown by the money supply/ money demand diagram), and translates into shifting up the LM curve.

Here is the effect in the ISLM model:

All other things being equal, the rise in prices has shifted up the LM curve, which has meant the equilibrium interest rate that brings the money market into equilibrium is higher at all levels of output. Given that the IS curve is unchanged, it means the money and goods markets will come into equilibrium at a higher interest rate. On the IS curve, a higher interest rate means that we will have a lower equilibrium level of output, because higher interest rates mean firms invest less, investment falls, so output falls.

When prices rise and everything else stays the same, output falls.

This is basically the downward sloping AD relation, it says rising prices = falling output.

The AD curve tells you the equilibrium level of output in the goods and money markets, for any given price level. Anything which will change the equilibrium level of output at all price levels, will shift the whole AD curve. So you can basically think of this as anything ‘happening’ in the ISLM model which will cause the equilibrium level of output to change apart from a change in the price level, which is captured in the downward slope of the AD line.

So the AD curve shifts out to the right, if you have a fiscal expansion or a monetary expansion, or anything that will increase consumer confidence to encourage consumers to spend more (which means the IS curve shifts out just like the fiscal expansion)

The AD curve shifts in to the left, if you have a fiscal contraction or a monetary contraction, or anything that will decrease consumer confidence to cause consumers to spend less (which means the IS curve shifts in just like the fiscal contraction)

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Categories: Aggregate Demand, Macro
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