The dynamic model of aggregate demand and aggregate supply combines five economic relationships: an equation for the goods market, which relates quantity demanded to the real interest rate; the Fisher equation, which relates real and nominal interest rates; the Phillips curve equation, which determines inflation; an equation for expected inflation; and a rule for monetary policy, according to which the central bank sets the nominal interest rate as a function of inflation and output.
The long-run equilibrium of the model is classical. Output and the real interest rate are at their natural levels, independent of monetary policy. The central bank’s inflation target determines inflation, expected inflation, and the nominal interest rate.
The dynamic AD–AS model can be used to determine the immediate impact on the economy of any shock and can also be used to trace out the effects of the shock over time.
Because the parameters of the monetary-policy rule influence the slope of the dynamic aggregate demand curve, they determine whether a supply shock has a greater effect on output or inflation. When choosing the parameters for monetary policy, a central bank faces a tradeoff between output variability and inflation variability.
The dynamic AD–AS model typically assumes that the central bank responds to a 1-percentage-point increase in inflation by increasing the nominal interest rate by more than 1 percentage point, so the real interest rate rises as well. If the central bank responds less vigorously to inflation, the economy becomes unstable. A shock can send inflation spiraling out of control.