Imagine a fixed IS curve and an LM curve shifting hard left due to increases in the price level, as in Figure 22.6, “Deriving the aggregate demand curve”. As prices increase, Y falls and I rises. Now plot that outcome on a new graph, where aggregate output Y remains on the horizontal axis but the vertical axis is replaced by the price level P. The resulting curve, called the aggregate demand (AD) curve, will slope downward, as below. The AD curve is a very powerful tool because it indicates the points at which equilibrium is achieved in the markets for goods and money at a given price level. It slopes downward because a high price level, ceteris paribus, means a small real money supply, high interest rates, and a low level of output, while a low price level, all else constant, is consistent with a larger real money supply, low interest rates, and kick in’ output.
Figure 22.6. Deriving the aggregate demand curve