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The AD curve shows a negative relationship between two economic variables: real GDP and inflation.
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The relationship between the inflation rate and the real interest rate is called the
monetary policy rule
.
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When inflation rates rise, the Federal Reserve responds by raising the real interest rates (through a more than proportional increase in
the nominal interest rate) and vice versa.
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Real Interest rate = Nominal Interest Rate minus the expected inflation rate.
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There is an inverse relationship between real GDP and inflation because an increase in inflation leads to a higher interest rate, which
leads to a decrease in real GDP.
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Movements along the AD curve and shift of the AD curve:
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A change in real GDP due to a change in inflation is a movement along the aggregate demand curve.
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Shifts of AD curve can be caused by:
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Government Purchases (increase in government purchases shifts AD to the right).
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2) Inflation Target Rate: A higher inflation target lowers interest rate.
AD curve will shift right.
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A lower inflation target increases interest rate.
AD curve will shift left.
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3) An increase in net exports, consumption and decrease in taxes will lead to AD curve shifting right.
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The Inflation Adjustment line is a flat line showing the level of inflation in the economy at any point in time.
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This note was uploaded on 02/13/2012 for the course ECON 2 taught by Professor Staff during the Fall '10 term at Santa Clara.
 Fall '10
 staff
 Inflation, Monetary Policy

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