ECON 1101 Chapter Notes - Chapter 12: Aggregate Supply, Virtuous Circle And Vicious Circle, Real Interest Rate

• School: Dalhousie University
• Department: Economics
• Course: ECON 1101
• Professor: T.Cyrus

Document Summary

It is not realistic to assume that prices stay constant, as the basic keynesian model assumes. Instead we will use the aggregate demand-inflation adjustment diagram to incorporate inflation. A monetary policy rule describes how the action a policymaker takes depends on the state of the economy. The bank of canada"s monetary policy rule says to raise interest rates if inflation rises and to lower interest rates if inflation falls. Their actual rule is to keep inflation between 1 and 3 percent. Here is a possible monetary policy rule: rate of inflation . Figure 12. 2 shows this monetary policy rule graphically. Aggregate demand (adi) curve: shows the relationship between short-run equilibrium output and inflation. Increases in inflation reduce planned spending and short-run equilibrium output, so the adi curve is downward-sloping. Aggregate demand is downward-sloping because of the central bank monetary policy rule. If inflation is high, the central bank will raise interest rates according to the reaction function.