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## The IS-curve in the AS-AD model
We can define an IS-curve in the AS-AD model in exactly the same way as in the IS-LM model: it will give us all combinations of where the goods market is in equilibrium, that is, where aggregate demand is equal to GDP, Y = Y.YD(Y, R) Since will not affect the IS curve. The IS curve in the AS-AD model is exactly the same as IS-curve in the IS-LM model.P ## The LM-curve in the AS-AD model
The LM-curve in the AS-AD model is slightly more complicated as and R where the money market is in equilibrium, that is, where the demand for money is equal to the supply of money, Y = MD(Y, R) MS.In the AS-AD model, the LM-curve shows all combinations of For a given P, we can still draw the LM curve in the AS-AD model just as we did in the IS-LM model. For a given P, there are different combinations of for a given P. and R where the money market is in equilibrium. Y set of combinations of But for another given P, another and R will be associated with equilibrium in the money market. Y This means that the LM-curve will shift when P changes.
1. First consider the top left figure. The demand curve for money, M, is drawn for = 10. The equilibrium interest rate is P = 5%.R 2. = 5% will provide us with a point on the LM1 curve to the right.R 3. Now suppose that 4. We see that = 100 Y in the money market.is no longer an equilibrium 5. To the left you see that = 100 for Y = 20.P 6. = 100 must be on a new LM curve (LM2) associated with the higher price Y = 20.P There is an LM curve for = 20 (LM2). The important thing to remember is that in the AS-AD model, there is one LM-curve for each value of P. P The reason, again, is that When P increases, the LM curve will shift to a new curve which will be above the old one. must increase when R increases to keep the money market in equilibrium.P ## Equilibrium in both the goods and in the money market
and R depend on P.Y
LM1 is the LM curve when = 20. LM2 is above LM1 as explained in the previous section. If Y1 and R1 are the equilibrium values when P = 10 and Y2 and R2 are the equilibrium value when P = 20, P we see that Y2 < Y and that R2 > R .We may draw the following conclusion. 1. When 2. When 3. When 4. When Of less importance is the following point: when GDP falls in step 4, More importantly, P.## The AD curve
From the section above, we know that increases if we want both markets to remain in equilibrium. In this section we derive the exact relationship between P and Y when both markets are in equilibrium.P
We can illustrate our derivation using the diagram above. 1. First select = 20 in the lower diagram.P2 2. Draw the IS curve in the upper diagram and two LM curves - the one corresponding to = 10.P 3. Identify the resulting GDP in the upper graph for both prices - the highest level of GDP is associated with the lower of the prices. 4. Extend these levels of GDP to the lower graph. This will result in two points in the lower graph. 5. Keep on doing this with other prices. The resulting downward sloping curve in the lower graph is called the AD-curve. Keep in mind that both the goods market and the money market is in equilibrium at all points on the AD curve. Therefore, the AD-curve alone cannot identify to which point the economy will move. ## The AD curve is the aggregate demand
The AD curve shows not only the equilibrium combinations of - it also shows the Y This follows from the equilibrium condition in the goods market which requires aggregate demand to be equal to GDP. When we change P, the AD curve will tell us the response of aggregated demand as a function of P when both markets are in equilibrium. and therefore also the response of Y You may therefore use the AD curve to find the aggregate demand for different prices under the condition that both markets are in equilibrium.YD. Initially, this may seem like a contradiction. In section 12.2.3, we claimed that the only endogenous variables that affect aggregate demand where does not affect P as long as we kept the YD and R fixed.Y • If we start in equilibrium and change and R constant, Y will YD change but we will not not longer be in equilibrium in the money market.• If we require both markets to be in equilibrium, must change when Y changes.P • Specifically, must increase when Y decreases if both markets are to be in equilibrium.P • Since and negatively on Y will then increase.RtYe • Thus, |

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