IS-LM model of aggregate demandThere is another major model that is useful for explaining the nature of the aggregate demand curve. This model is called the IS-LM model after the two curves that are involved in the model. The IS curve describes equilibrium in the market for goods and services where Y = C(Y - T) + I(r) + G and the LM curve describes equilibrium in the money market where M/P = L(r,Y). The IS-LM model exists in a plane with r, the interest rate, on the vertical axis and Y, being both income and output, on the horizontal axis. The IS-LM model has the same horizontal axis as the aggregate demand curve, but a different vertical axis.The IS curve describes equilibrium in the market for goods and services in terms of r and Y. The IS curve is downward sloping because as the interest rate falls, investment increases, thus increasing output. The LM curve describes equilibrium in the market for money. The LM curve is upward sloping because higher income results in higher demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the LM curve shows the equilibrium interest rate and price level.

The IS curve and the LM curve shift in response to economic activities. The IS curve shifts outward as a result of increased government purchases, exogenous increases in investment, decreases in taxes, and exogenous increases in consumption. The IS curve shifts inward as a result of decreases in government purchases, exogenous decreases in investment, increases in taxes, and exogenous decreases in consumption. The LM curve shifts outward as a result of increases in the money supply and decreases in the price level. The LM curve shifts inward as a result of decreases in the money supply and increases in the price level.The aggregate demand curve can be derived using the IS-LM model. Recall that the aggregate demand curve relates price level to income and output. The simplest way to derive the downward sloping aggregate demand curve from the IS-LM model is to look at the effects of an increase in the price level on output or income.When the price level increases, the LM curve shifts inward. An inward shift in the LM curve results in an intersection of the IS-LM model at a lower level of output and income and a higher interest rate. When a line connecting the old price level and the old output and income to the new price level and the new output and income in the price level and output and income space, the downward sloping aggregate demand curve appears. In general, from the IS-LM model, it is clear that aggregate demand slopes downward because as the price level increases, output and income decrease.The IS-LM curve is a useful way to incorporate the money market into the logic driving the aggregate demand curve. By understanding the basics of the IS-LM model and the three reasons that the aggregate demand curve is downward sloping as presented under the previous heading, the nature of the aggregate demand curve is clear. The next step to work through is how shifts of and shifts along the aggregate demand curve function. In this capacity, the IS-LM model will become very useful.The IS curve describes equilibrium in the market for goods and services in terms of r and Y. The IS curve is downward sloping because as the interest rate falls, investment increases, thus increasing output. The LM curve describes equilibrium in the market for money. The LM curve is upward sloping because higher income results in higher demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the LM curve shows the equilibrium interest rate and price level.