Movement along the ADI curve. A change in government purchases would increase real GDP through aggregate spending and the multiplier effects on income. Monetary policy would work through the effect of lower interest rates on the interest-sensitive spending components, net exports and investment, and would be less immediate in effect. This is exactly the same as the example used in class in which the government increased defense expenditures. In this case, though, the ADI curve shifts to the right due to the increased highway construction.
Inflation remains fixed due to sticky prices.
Inflation begins to rise as illustrated by an upward shift in the PA line. This means that the Fed will raise interest rates, consistent with its policy rule. Interest rates are higher than baseline. Price shocks and the Fed. Since GDP is below potential GDP, the PA line will adjust do wnward and move the economy back to potential GDP along the ADI curve.