Shock

By the time most students exit undergrad, they get acquainted with the Aggregate Supply – Aggregate Demand model. I think that this model is so important that my Principles of Macro class spends twice the amount of time on it as on any other topic. The model is nice because it uses the familiar tools of Supply & Demand and throws a macro twist on them. Below is a graph of the short-run AS-AD model.

Quick primer: The AD curve increases to the right and decreases to the left. The Federal Reserve and Federal government can both affect AD by increasing or decreasing total spending in the economy. Economists differ on the circumstances in which one authority is more relevant than another.

The AS curve reflects inflation expectations, short-run productivity (intercept), and nominal rigidity (slope). If inflation expectations rise, then the AS curve shifts up vertically. If there is transitory decline in productivity, then it shifts up vertically and left horizontally.

Nominal rigidity refers to the total spending elasticity of the quantity produced. In laymen’s terms, nominal rigidity describes how production changes when there is a short-run increase in total spending. The figure above displays 3 possible SR-AS’s. AS0 reflects that firms will simply produce more when there is greater spending and they will not raise their prices. AS2 reflects that producers mostly raise prices and increase output only somewhat. AS1 is an intermediate case. One of the things that determines nominal rigidity is how accurate the inflation expectations are. The more accurate the inflation expectations, the more vertical the SR-AS curve appears.*

The AS-AD model has many of the typical S&D features. The initial equilibrium is the intersection between the original AS and AD curves. There is a price and quantity implication when one of the curves move. An increase in AD results in some combination of higher prices and greater output – depending on nominal rigidities. An increase in the SR-AS curve results in some combination of lower prices and higher output – depending on the slope of aggregate demand.

Of course, the real world is complicated – sometimes multiple shocks occur and multiple curves move simultaneously. If that is the case, then we can simply say which curve ‘moved more’. We should also expect that the long-run productive capacity of the economy increased over the past two years, say due to technological improvements, such that the new equilibrium output is several percentage points to the right. We can’t observe the AD and AS curves directly, but we can observe their results.

The big questions are:

What happened during and after the 2020 recession?
Was there more than one shock?
When did any shocks occur?

Below is a graph of real consumption and consumption prices as a percent of the business cycle peak in February prior to the recession (See this post that I did last week exploring the real side only). What can we tell from this figure?

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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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