Fall Semester ’05-’06
Akila Weerapana
Lecture 17: The Aggregate Demand/Aggregate Supply Model
I. OVERVIEW
•By now, you should be familiar with the basic IS-LM model and be able to use it to analyze
real-world economic issues. As the last lecture indicated, the IS-LM model, despite its sim-
plicity, is very powerful and can be used to understand several interesting types of economic
developments.
•However, a significant weakness still remains, namely, the inability to think about how changes
in the economy affect inflation. In other words, even though we have the Solow model to think
about the economy in the long run and the IS-LM model to think about the economy in the
short run, we have no intermediate run model.
•In the next few lectures we will extend the IS-LM model so as to be able to use it for thinking
about price adjustment. In today’s class, we will derive the basic components of the model:
an aggregate demand curve and an aggregate supply curve and then put the model together
and use it in the next few classes.
II. USING THE IS-LM MODEL TO OBTAIN AN AGGREGATE DEMAND
CURVE
•The aggregate demand curve summarizes the relationship between the price level and the
quantity of domestic output demanded by consumers, firms, the government and foreigners.
•Graphically, we can derive this curve from the IS-LM diagrams. Consider an increase in the
price level P. When Pgoes up, money demand increases, bringing about an excess demand
for money - the LM curve shifts inward raising rand lowering Y. When Pgoes down, money
demand decreases, bringing about a an excess supply of money - the LM curve shifts outward
lowering rand raising Y.
•By repeating this experiment for different price levels we can map out the negative relationship
between Pand Yalong the AD curve.
IS-LM Model
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6
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@
r
Y
IS
LM (P0)
LM00 (P2)
LM0(P1)
Y0
r0
Y1
r1
Y2
r2
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AD Model
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6
P
Y
AD
Y0
P0
Y1
P1
Y2
P2
