Syllabus T. Y. B. A. Paper : IV advanced economic theory with effect from academic year 2010-11 in idol

9.2 
DETERMINATION 
OF 
PRICE 
LEVEL 
AND 
AGGREGATE OUTPUT USING AD AND AS CURVES 
 
The relation between price level and aggregate demand is 
analysed on the assumption that output is determined by demand. 
This implies that firm can easily produce whatever output is 
demanded. 
The Keynesian Model assumes that price level is constant. 
However, in reality price level does not remains constant. Inflation 
is an important macro economic issue in modern times. It is 
possible to derive aggregate demand and aggregate supply 
related to different price levels. 
 

---

1
i
2
i
When the price level is allowed to change, there is change in 
supply of real money balance. This causes a shift of LM curve and 
shift of equilibrium output in the IS 
– LM analysis. Therefore it is 
possible to derive macroeconomic demand schedule showing 
different combination of price level and real income and thus 
construct the aggregate demand curve. 
 
The shift of LM curve due to an increase in supply of real 
money balance caused by a fall in the price level is shown in the 
following diagram. 
 
FIGURE 9.1: CHANGE IN THE PRICE LEVEL 
The supply of real money balance is defined as M/P. The 
initial equilibrium is E
1
in the Panel A of the diagram where the 
demand curve ‗L‘ intersect the initial money supply curve and 
equilibrium rate of interest is given as i
1
. 
In the supply of real balance M/P, the nominal money ‗M‘ is 
remains constant and price level ‗P‘ allowed to fall from P
1
to P
2
. As 
a result the supply curve of real balance shift to the right and new 
equilibrium is E
2
and rate of interest falls to i
2
. But the two 
equilibrium positions are associated with same level of income 
namely ‗Y‘. In Panel B of the diagram, this is shown as shift of LM 
curve down and to the right.