The aggregate demand curve shows the combinations of the price level and the level of output at which the goods and money markets are simultaneously in equilibrium. Let us now go on to the derivation of the aggregate demand.
In the figure the aggregate demand curve is derived from the IS-LM framework. Suppose the given price level is P0 and the nominal stock of money is . The real stock of money is then and the LM curve corresponding to this stock of real money is shown in the top panel of figure 6.1.
The IS curve is also shown.
The economy is at the equilibrium point E. The output is Y0 and the interest rate is i0. Thus when the price level is P0, the goods and the money markets are in equilibrium at an income level of Y0.
The point E in the lower panel of figure 6.1 shows the income and price combination (Y0, P0).
Now, if the price level falls from P0 to Pl, the real stock of money in the economy increases to (for the same nominal stock of money ). This increase in the real stock of money shifts the LM curve downwards to LMl . The new equilibrium is at the point El. At El, the income is higher at Yl and the interest rate is lower at il. Thus when the price level is Pl, the goods and the money market are in equilibrium at an income level of Yl. We see that when the price level falls from P0 to Pl, the income level rises from Y0 to Yl. The converse happens when the price level rises. Thus we get a downward sloping aggregate demand curve.