Something's been puzzling me about the data for the last couple of years. (This post isn't very clear, sorry. I can't even get my head clear enough to explain clearly what's unclear to me.)
There are two curves in short run macroeconomics: the AD curve, and the "other" curve. This post is not about the AD curve. It's about that other curve. The other curve is the one that tells us what happens when the AD curve shifts exogenously. The other curve tells us whether a shift in the AD curve will affect real variables or nominal variables or both. Theory tells us that the other curve should be close to vertical in the long run, when AD affects only nominal variables. I'm more interested in that other curve in the short run.
In particular, if we put the levels of real variables on the horizontal axis, what belongs on the vertical axis of the other curve? Is it levels, or rates of change? Is it the price level, or the inflation rate? Does it matter?
We don't normally observe that other curve. We would only observe that other curve if the AD curve shifted around at random, tracing out a path along that other curve. But the whole point of having good monetary policy is to ensure that the AD curve doesn't shift around at random. We can't normally econometrically identify that other curve, because the job of a good central bank is to make life impossible for econometricians by making damn sure there aren't any monetary policy shocks.
But the last three years have given us a natural experiment. Monetary policy failed to do its job right. (Or was unable to do its job right, if you insist, because I don't want to argue it here). So we actually get to see what that other curve looks like.
Here's my take on the data. (Here's Canada, for example). For most countries, real output is currently below trend and unemployment is currently above trend. There is not yet a full recovery from the recession. The price level is below trend, but the inflation rate is back on trend. The data suggest, to me, that we need to put the price level, and not the inflation rate, on the vertical axis of the other curve.
And I find that puzzling.
(I'm not saying there's a good relationship between the depth of the recession and the deviation of the price level from trend. I'm just saying I think it's better than the relationship between the depth of the recession and the deviation of the inflation rate from trend.)
We have two names for the short run version of that "other" curve: the Short Run Aggregate Supply Curve; and the Short Run Phillips Curve. They are sort of the same thing. Both are supposed to show us what happens, in the short run, when there's an exogenous unexpected shift in the AD curve. When teaching macro, we normally switch from one to the other by just waving our hands.
The names sure sound different. But these are just names. The SRAS curve isn't necessarily a supply curve, because it needn't show what firms want to sell in a recession; it shows what they do in fact sell. We could think of it as a price-setting curve instead. We might read a SRAS curve from right to left, with output as a function of price, but we could equally read it from left to right, with price as a function of output.
The SRAS curve has real output on the horizontal axis, and the SRPC has the unemployment rate on the horizontal axis, but that's no big deal. If there's a sudden leftward shift in the AD curve, unemployment rises and output falls. So SRAS slopes up, and SRPC slopes down, but it's the same thing.
It's the vertical axis I'm talking about here. The SRAS curve has the price level on the vertical axis, and the SRPC has the inflation rate on the vertical axis. Does that matter?
Until a couple of years ago, I would have said that it didn't matter.
Start with: Y(t)-Yn = B[P(t)-E(P(t))]
Do some trivial arithmetic and get: P(t)-P(t-1)=E(P(t))-P(t-1) + (1/B)[Y(t)-Yn]
The first one says that the output gap depends on the gap between the price level and the expected price level. Sounds like an Expectations-Augmented Aggregate Supply Curve.
The second one says that actual inflation equals expected inflation plus some function of the output gap. Sounds like an Expectations-Augmented Phillips Curve.
But they are the same equation. And it shouldn't matter if we use one or the other.
Yet when I look at the data for the last three years, my brain wants to tell a story in levels, not rates of change. Does it take three years for expectations of the price level to adjust?
Someone [Milton Friedman, thanks Gregor] said that the only advance in macroeconomics in the 200 years since David Hume was to slip one derivative. I'm not sure if that was an advance.