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.

Figure 

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 P^l, 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 LM^l    . The new equilibrium is at the point E^l. At E^l, the income is higher at Y^l and the interest rate is lower at i^l. Thus when the price level is P^l, the goods and the money market are in equilibrium at an income level of Y^l. We see that when the price level falls from P⁰ to P^l, the income level rises from Y⁰ to Y^l. The converse happens when the price level rises. Thus we get a downward sloping aggregate demand curve.