ABSTRACT
This chapter examines how changes in the price level affect aggregate demand. The chapter visualizes the Aggregate Demand (AD) curve by identifying two points on it that are defined by two arbitrary price levels. An increase in prices shifts the liquidity-money (LM) curve to the left because it reduces the real money supply for every given nominal quantity of money. This equivalence between price changes and monetary policy was discovered by Keynes, and is known as the Keynes effect. The reduction in the real money supply causes interest rates to rise, just as would a contractionary monetary policy, and that discourages investment. An increase in prices reduce the level of aggregate demand as it is determined by the IS-LM equilibrium. The Simulative fiscal or monetary policies both shift the AD curve out, while contractionary policies shift the AD curve in.
