provide an explanation of the dynamics of economic fluctuations, particularly inflation and real GDP. The economic fluctuations model is constructed by first deriving the aggregate demand/inflation curve and then the price adjustment line. The model can be used to study the determination of real GDP and the price level.
Teaching Objectives 4. Explain the primary factors that determine location of the ADI curve. This occurs through the components of aggregate spending that are sensitive to interest rates (spending balance) and the policy rule. 5. Explain the factors that shift the ADI curve: Changes of the policy rule and changes in government spending, along with autonomous shocks to aggregate spending, determine the
Teaching Objectives • 6. Introduce the microeconomic basis of price adjustment. 7. Explain the PA line and the factors that cause it to shift. 8. Explain how the intersection of the ADI curve and the PA line determines the level of equilibrium real GDP and the inflation rate at some point in time in the economy.
• As real (inflation-adjusted) interest rate goes up, cost of borrowing goes up, so that business investment (buying a new machine or extending business) and housing investment declines. • As real interest rate declines, investment goes up, because the cost of investment declines
STAGE 3: Deriving AD curve • When inflation increases, two things happen: (1) Central banks raise the nominal interest rate more than inflation, raising the real interest rate (2) The higher real interest rate will decrease real GDP because of lower AE • Just the opposite happens when inflation decreases • Thus, AD curve shows a negative link between real interest rates and real GDP