1.1 Aggregate Demand/Supply:A Compact Repre- sentation In developing this baseline model,it is useful to keep in mind that what monetary policy can influence is the deviation of economic activity from its natural level.Within our baseline model,the natural level of economic ac- tivity is defined as the equilibrium that would arise if prices were perfectly flexible and all other cyclical distortions were absent.In the limiting case of perfect price flexibility,accordingly,the framework takes on the properties of an real business cycle model.One difference with the latter is that because there is monopolistic competition as opposed to perfect competition,the nat- ural level of economic activity is below the socially efficient level.However, this distinction does not affect the nature of the associated cyclical dynamics of the natural level of economic activity which,within our baseline frame- work,resemble those of an real business cycle model with similar preferences and technology. Aggregate Demand.The aggregate demand relation is built up from the spending decisions of a representative household and a representative firm.In the baseline model,both capital and insurance markets are perfect. Within this frictionless setting,the household satisfies exactly its optimiz- ing condition for consumption/saving decisions.It thus adjusts its expected consumption growth positively to movements in the expected real interest rate.Similarly,with perfect capital markets,the representative firm satisfies exactly its optimizing condition for investment:it varies investment propor- tionately with Tobin's g,the ratio of the shadow value of installed capital to the replacement value. 91.1 Aggregate Demand/Supply: A Compact Repre￾sentation In developing this baseline model, it is useful to keep in mind that what monetary policy can ináuence is the deviation of economic activity from its natural level. Within our baseline model, the natural level of economic ac￾tivity is deÖned as the equilibrium that would arise if prices were perfectly áexible and all other cyclical distortions were absent. In the limiting case of perfect price áexibility, accordingly, the framework takes on the properties of an real business cycle model. One di§erence with the latter is that because there is monopolistic competition as opposed to perfect competition, the nat￾ural level of economic activity is below the socially e¢ cient level. However, this distinction does not a§ect the nature of the associated cyclical dynamics of the natural level of economic activity which, within our baseline frame￾work, resemble those of an real business cycle model with similar preferences and technology. Aggregate Demand. The aggregate demand relation is built up from the spending decisions of a representative household and a representative Örm. In the baseline model, both capital and insurance markets are perfect. Within this frictionless setting, the household satisÖes exactly its optimiz￾ing condition for consumption/saving decisions. It thus adjusts its expected consumption growth positively to movements in the expected real interest rate. Similarly, with perfect capital markets, the representative Örm satisÖes exactly its optimizing condition for investment: it varies investment propor￾tionately with Tobinís q, the ratio of the shadow value of installed capital to the replacement value. 9