Question

How does one derive a Keynesian AD curve? What is on Y axis and what is on X axis? Briefly explain.

Answer 1

AD curve is the demand curve that includes goods and money market. Goods market is represented by the IS curve and the money market is represented by the LM curve.

The intersection of both IS and LM curve shows that both goods and money market are in equilibrium.

In the diagram, both curves intersect at point E, the output level is Y1 and interest rate is i. The corresponding price on the second figure is P and equilibrium point E.

Now, let say the Central Bank increases the flow of money supply. This will cause the rightward shift in the LM curve from LM to LM1. Economy moves from point E to E1 and the corresponding price on 2nd figure. is P1 given by point E1.

If we join two points, then we get the downward sloping AD curve.

LM i1 LM' E . 17 IS у» Prices p Pin AD Y YI Y->

On X-axis, Aggregate output/spending is shown

On Y-ais, price level is shown