The aggregate demand–inflation adjustment model builds on the concepts of the

IS–LM model The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic model which is used as a pedagogical tool in macroeconomic teaching. The IS–LM model shows the relationship between interest rates and output in the short run in a ...

and the

AD–AS model The AD–AS or aggregate demand–aggregate supply model (also known as the aggregate supply–aggregate demand or AS–AD model) is a widely used macroeconomic model that explains short-run and long-run economic changes through the relationship ...

s, essentially in terms of changing

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...

s in response to fluctuations in

inflation In economics, inflation is an increase in the average price of goods and services in terms of money. This increase is measured using a price index, typically a consumer price index (CPI). When the general price level rises, each unit of curre ...

rather than as changes in the

money supply In macroeconomics, money supply (or money stock) refers to the total volume of money held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circulation (i ...

in response to changes in the

price level The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set. ...

The model

The AD–IA model is a

Keynesian Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output an ...

method used to explain economic fluctuations. This model is used to show undergraduate students how shifts in demand or shocks to prices can affect real GDP around potential. The model assumes that when inflation rises the interest rate rises (monetary policy rule). It also assumes that when real GDP exceeds potential, there is upward pressure on the inflation rate and vice versa. The model features a downward-sloping demand curve (AD) and a horizontal inflation adjustment line (IA). The point where the two lines cross is equal to potential GDP. A shift in either curve will explain the impact on real GDP and inflation in the short run.

Assumptions

The AD–IA model depends on the assumption of the monetary policy rule (MPR). The monetary policy rule is that the federal reserve increases interest rates in response to increase in

and vice versa.

Shifts in demand

A shift in demand can occur for the following reasons: * A change in government spending * A change in consumption * A change in taxes * A change in the monetary rule ''Example'': Suppose the government were to cut taxes. This would lead to an increase in expenditures and thus an increase in demand. The demand curve would therefore shift to the right and real GDP would be growing above potential. The inflation adjustment line would then shift upward (reflecting an increase in the inflation rate) causing a movement along the new demand curve until real GDP was equal to potential.

More advanced

This model is further advanced in higher levels of undergraduate studies.

David Romer David Hibbard Romer (born March 13, 1958) is an American economist, the Herman Royer Professor of Political Economy at the University of California, Berkeley, and the author of a standard textbook in graduate macroeconomics as well as many influ ...

proposed in 2000 that the LM curve be replaced in the IS–LM model. Instead, Romer suggested that although the Federal Reserve uses

open market operation In macroeconomics, an open market operation (OMO) is an activity by a central bank to exchange liquidity in its currency with a bank or a group of banks. The central bank can either transact government bonds and other financial assets in the ope ...

s to impact the federal funds rate, they are not targeting

, but rather the

. Therefore, he suggested removing the LM curve and replacing it with the MP curve of the IS/MP model, IS–MP model.

References

External links