• The AD curve shows a negative relationship between two economic variables: real GDP and inflation. • The relationship between the inflation rate and the real interest rate is called the monetary policy rule . • 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. • Real Interest rate = Nominal Interest Rate minus the expected inflation rate. • 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. • Movements along the AD curve and shift of the AD curve: • A change in real GDP due to a change in inflation is a movement along the aggregate demand curve. • Shifts of AD curve can be caused by: • Government Purchases (increase in government purchases shifts AD to the right). • 2) Inflation Target Rate: A higher inflation target lowers interest rate. AD curve will shift right. • A lower inflation target increases interest rate. AD curve will shift left. • 3) An increase in net exports, consumption and decrease in taxes will lead to AD curve shifting right. • 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.