Answer to Question #242027 in Economics for Zarah

Question

1. Brief note. Derive AD curve using IS-LM model and explain in words.

2. Brief note. Explain why long-run aggregate supply schedules are drawn vertically and short-run AS schedules are upward-sloping.

Answer 1

The equilibrium of the IS-LM model allows you to determine not only the equilibrium interest rate and income but also the effective demand.

Effective demand is the amount of aggregate demand that corresponds to the joint equilibrium in the markets for goods and money.

The initial equilibrium of the IS-LM model is at the point E1 (i1; Y1). This point can be projected onto the AD curve as point A. The volume of aggregate demand Y1 will be established at the price level in the economy P1. If the price level rises to P2, then the real amount of money will decrease

(LM1 → LM2). A new joint equilibrium of the IS-LM model will be established

at the point E2 (i2; Y2). Therefore, at the price level P2, the volume of effective demand will be Y2 (point B). If the price level drops to Y3, then the real amount of money will increase and the LM curve will shift to the right (LM1 → LM3). A new joint equilibrium will be established at point E3 (i3; Y3). At the price level P3, the volume of effective demand will be Y3 (point C). Connecting points A, B, and C - we get the aggregate demand function AD.

The IS curve will not change its position.

The AD curve reflects the inverse relationship between the price level

and the volume of purchases of goods and services. It has a decreasing character (lower prices correspond to a larger amount of cash balances and, accordingly, a higher aggregate demand).

There are two main reasons why the volume of the proposed aggregate output may increase when the price level P rises, i.e. why the AS curve has an upward slope: The short-term AS curve is plotted taking into account some nominal variables, such as the nominal wage rate, which is assumed to be fixed in the short run.