ABSTRACT
Central banks in modern advanced countries manage the money supply and interest rates so that unemployment rates and inflation rates remain under control. Replacing the traditional liquidity-money (LM) curve with the central bank reaction function requires to replace the traditional aggregate demand (AD) curve with a version of the AD curve that shows how aggregate demand responds to different inflation rates, rather than different price levels. This can be easily accomplished by combining the investment-saving (IS) curve and the reaction function (RF), calling the result the IS-RF model. Since the reaction function replaces the LM curve, it can easily be combined with the IS curve to describe the equilibrium level of aggregate demand. The theory behind the dynamic aggregate demand curve involves active monetary policy rather than the Keynes effect that generated the static AD curve. The IS-RF model can be effectively used to analyze monetary policy, fiscal policy, and various supply-side disturbances.
