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The IS and LM curves together determine the AD schedule. The AD curve maps out the IS-LM equilibrium.

**AD curve is drawn on the basis of following assumptions: **

1. A Constant.

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2. Nominal Money Supply (M) is constant.

3. Only Price level varies [because AD shows inverse relationship between price and quantity demanded],

AD curve shows the amount of equilibrium output demanded at each price level.

**Derivation of AD Equation: **

When the price level increases with nominal money supply constant, the real money supply (M/P) will decrease.

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This in turn will lead to an increase in the interest rate which in turn will decrease the investment. As a result the LM curve will shift upwards to the left and AD will decrease.

Thus, Y_{1} corresponds to point E_{1} on AD curve at point level P_{1} in the lower panel.

As a result LM curve will shift upwards to the left from LM_{1} to LM_{2} and new equilibrium is established at point E_{2}.

At point E_{2}: IS = LM_{2}

Equilibrium income → Y_{2} (Y_{2} < Y_{1}); interest rate rises to i_{2} (i_{2}> i_{1})

Y_{2} corresponds to point E_{2} on the AD curve at price level P_{2} and we get point E_{2} in the lower panel.

Similarly, we can generate many points on the AD curve.

By joining the points E_{1} and E_{2}, the AD curve is derived which is negatively sloped showing price and output level are inversely related.

This is because:

When P ↑ → real balance (M/P) ↓ → ↑I → ↓ AD → ↓ Y