[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Because equilibrium GDP is determined by aggregate expenditures in the short
run, we can also say that there is a negative relationship between inflation and
the short-run equilibrium level of GDP, given the central bank’s policy rule. This
relationship between inflation and GDP is called the aggregate demand–inflation
(ADI) curve and is shown in Figure 31.2. Output (GDP) is on the horizontal
axis, and inflation is on the vertical axis. The ADI curve in Figure 31.2 shows equilibrium
output at each rate of inflation. If the inflation rate is π 0 , equilibrium output
will equal Y 0 . At a higher inflation rate such as π 1 , equilibrium output will be lower,
equal to Y 1 .
What Determines the Slope of the ADI Curve? When we use a demand
and supply framework to analyze how price and quantity are determined, both the
positions and the slopes of the demand and supply curves are important. Similarly,
the adjustment of inflation and output to economic disturbances will depend on
whether the ADI curve is relatively flat or relatively steep. Changes in inflation lead
to changes in equilibrium output that are large when the ADI curve is relatively
flat but small when the ADI curve is relatively steep. Understanding the
factors that determine the slope of the ADI curve will be important for
understanding the behavior of the economy in the short run.
The slope of the ADI curve in the closed economy has two main determinants.
The first important factor is how the central bank adjusts interest
rates as inflation changes—that is, the monetary policy rule. When
the central bank responds more aggressively, a change in inflation will
result in a larger change in the real rate of interest. A given change in
inflation then leads to a larger fall in aggregate expenditures, making
the ADI curve relatively flat. In contrast, a weaker reaction by the central
bank will lead to a smaller rise in the real interest rate and a smaller
decline in aggregate expenditures. As a result, the ADI curve will be
relatively steep.
The second factor that affects the slope of the ADI curve is the
impact of the real interest rate on the decisions by households and firms
about how much to spend on consumption and investment. For example,
if investment spending is very sensitive to the real interest rate,
then the ADI curve will be quite flat—that is, a given change in the real
interest rate caused by inflation will lead to a large change in aggregate
expenditures. If investment and household spending do not respond
much to changes in the real interest rate, then the ADI curve will
be steep.
Figure 31.3 illustrates two different ADI curves. In an economy where
the central bank responds aggressively to changes in inflation, or investment
spending is very sensitive to changes in the real interest rate, or both,
the ADI curve would be relatively flat, such as the curve labeled ADI 0 .
In an economy where the central bank responds weakly to changes in
inflation, or investment spending is not very sensitive to changes in the
real interest rate, or both, the ADI curve would be relatively steep, such
as the curve labeled ADI 1 .
INFLATION (π)
Figure 31.3
THE ADI SLOPE
Y f
OUTPUT (Y )
ADI 1
ADI 0
If monetary policy responds aggressively to changes
in inflation, or investment is sensitive to real interest
rates, or both, the ADI curve will be flat, as illustrated
by the curve ADI 0 . If monetary policy does not respond
strongly to changes in inflation, or investment is insensitive
to real interest rates, or both, the ADI curve will
be steep, as illustrated by the curve ADI 1 . The vertical
line at Y f denotes full-employment output. Both
ADI curves are drawn to be consistent with achieving
full-employment output at the same rate of inflation.
THE AGGREGATE DEMAND–INFLATION CURVE ∂ 693