AS-AD: From Levels to Percent

The aggregate supply & aggregate demand model (AS-AD) is nice because it’s flexible and clear. Often professors will teach it in levels. That is, they teach it with the level of output on one axis, and the price level on the other axis. This presentation is convenient for the equation of exchange, which can be arranged to reflect that aggregate demand (AD) is a hyperbola in (Y, P) space. Graphed below is the AD curve in 2019Q4 and in 2020Q2 using real GDP, NGDP, and the GDP price deflator.

The textbook that I use for Principles of Macroeconomics, instead places inflation (π) on the vertical axis while keeping the level of output on the horizontal axis. The authors motivate the downward slope by asserting that there is a policy reaction function for the Federal Reserve. When people observe high rates of inflation, state the authors, they know that the Fed will increase interest rates and reduce output. Personally, I find this reasoning to be inadequate because it makes a fundamental feature of the AS-AD model – downward sloping demand – contingent on policy context.

At the same time, I do think that it can be useful to put inflation on the vertical axis. Afterall, individuals are forward looking. We expect positive inflation because that’s what has happened previously, and we tend to be correct. So, I tell my students that “for our purposes”, placing inflation on the vertical axis is fine. I tell them that, when they take intermediate macro, they’ll want to express both axes as rates of change. I usually say this, and then go about my business of teaching principles.

But, what does it look like when we do graph in percent-change space?

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Inflation Empirics

Way back in the late 1970s and early 80s, Kydland and Prescott proposed rational expectations theory. This line of research arose, in part, because the Phillips curve ceased to describe reality well. Amid increasing inflation, people began to anticipate higher prices to a relatively correct degree when making labor, supply chain, and pricing decisions. Kydland and Prescott argued that individuals understand the rules of the game or how the world works – at least on average.

An increase in the money supply would increase total national spending, and increase demand for goods. However, firms also experienced increasing revenues and demanded more inputs such as commodities, capital, and intermediate goods. Because there were no greater productivity earlier in the supply chain, price roses. Firms began to understand that greater demand would eventually find its way to causing greater costs. Therefore, firms began raising prices before the cost of resources rose, increasing their willingness to pay for inputs and, ironically, hastening the increase in input prices. As a result, increases in the money supply began having substantial short-run price effects and negligible output effects.

However, assuming that people understand the rules of our economic system and ‘how the world works’ is hard to swallow. It is not at all clear that the typical economist understands monetary theory, much less clear that the typical person has a good understanding. Fortunately, another theory of expectations can help carry some of the load and achieve similar results.

Adaptive Expectations

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