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Chapter Review Chapter 13: Aggregate Demand and Inflation

  1. Aggregate demand depends negatively on inflation. As inflation increases, the Fed or other central bank raises interest rates, thereby reducing aggregate expenditures. This negative relationship is called the aggregate demand-inflation or ADI curve.
  2. At a given rate of inflation, the economy’s equilibrium level of output is given by the ADI curve.
  3. The slope of the ADI curve depends on the central bank’s behavior. If it increases interest rates sharply when inflation rises, the impact on aggregate demand will be large and the ADI curve will be relatively flat. If the bank responds less strongly to inflation changes, the ADI curve will be steeper.
  4. Changes in fiscal policy, private investment, consumption spending, or monetary policy at a given rate of inflation shift the ADI curve.
  5. The slope of the ADI curve also depends on the responsiveness of investment to interest rate changes. If increases in the real interest rate have a large impact on investment and spending, the ADI curve will be relatively flat.
  6. If GDP is below the full-employment level, inflation will fall, shifting the inflation adjustment line down and increasing equilibrium output. This process continues until full employment is restored.
  7. If GDP is above the full-employment level, inflation will rise, shifting the inflation adjustment curve up and decreasing equilibrium output. Eventually full employment is restored.
  8. Once inflation has adjusted, the economy will be at full employment. Shifts in the ADI curve affect GDP in the short run, but in the long run such shifts only affect the inflation rate.
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