Teaching SRAS shocks

I hate teaching Short Run Aggregate Supply shocks.

1. It's easy to teach them wrong.

2. I don't understand them very well.

3. I don't think anyone understands them very well.

Take the standard introductory or intermediate macro textbook. Put real income Y on the horizontal axis. Put the price level P on the vertical axis. (Or put inflation there instead, if you want). Draw a downward-sloping Aggregate Demand curve. Draw a vertical Long Run Aggregate Supply curve.

If you've only got those two curves, AD and LRAS, most of us think the model doesn't work very well in the short run. Because the model says that AD shocks will affect only P and not Y. Because the model says that fluctuations in Y can only be caused by LRAS shocks. And most of us think the world doesn't look like that.

So most of us add an upward-sloping (or maybe even horizontal) curve to the model. We call that third curve the "SRAS curve". We talk about nominal rigidities to motivate that third curve. We now think the model works much better in predicting the effects of AD shocks. Shifts in the AD curve affect Y in the short run, and only affect P in the long run.

But then we want to talk about SRAS shocks. That's when the trouble starts.

It is very easy to convince students that a short spell of bad weather causing a bad harvest could cause the SRAS curve to shift up and left while leaving the LRAS curve unchanged. After all, the weather is a short run supply shock that won't affect supply in the long run. 99% of students will happily accept that example.

But it's totally wrong. The LRAS curve tells us where the economy would be if there were no nominal rigidities. A short spell of bad weather would cause the LRAS curve to shift left for a short time, and would cause Y to drop even if there were no nominal rigidities. The long run right now is not just an average of short runs, even if the long run on average is the same as the short run on average (which it might or might not be, depending on whether the SRAS curve is linear).

Starting in full equilibrium, where all three curves intersect, what sort of shock would cause the SRAS curve to shift without causing the LRAS curve to shift?

1. Suppose a government replaces an income tax with a sales tax, or cuts the first and raises the second, in a revenue-neutral way. To a first approximation, if both taxes are roughly equally distorting, there will be no shift in the LRAS curve (yes, this is debatable, but set that aside). If there were no nominal rigidities, this change from one tax to another would have no effect on the price level. But if wholesale prices are sticky, and retail prices inclusive of tax are flexible, retailers may simply raise prices by the amount that sales taxes have increased. So the SRAS curve shifts up. The central bank should accommodate that upward shift in the SRAS curve by shifting the AD curve upwards by the same amount, to prevent a recession.

2. The classic example of the supply shock is the OPEC oil price increase of 1973. It is not obvious how this should affect the LRAS curve. It depends on whether the country is an oil importer or oil exporter. The terms of trade could either worsen or improve. It depends on whether the Y on the horizontal axis measures real output in terms of output prices or real income in terms of consumption prices. Either way, it is not at all obvious whether the SRAS curve will shift left or right, and whether it will shift left or right more or less than the LRAS curve shifts.

Take a country that is neither an oil exporter nor importer. There should be no first-order effect on that country's terms of trade and LRAS curve. All we know is that the exercise of monopoly power by a foreign producers' cartel restricting output of oil will increase the equilibrium relative price of oil. That says nothing about the effect on the average price level. It is perfectly compatible with all other prices falling, while the price of oil in domestic currency stays the same.

Here's the story I told my students. Suppose the price of oil in domestic currency is flexible, and the prices of non-oil products are sticky. Then the only way the relative price of oil can rise is if the nominal price of oil rises. So the price of gas at the pumps rises, but all other prices stay the same. So average prices rise. So the SRAS curve shifts vertically up. Again, the central bank should accommodate that upward shift in the SRAS curve by shifting the AD curve up by the same amount, to prevent a recession.

That's what I tell my students. But I am really not happy with my stories. Each one depends on a very ad hoc assumption about which prices are sticky and which prices are flexible. If I made the opposite ad hoc assumption I would get no shift in the SRAS curve.

As Brad DeLong notes, by adding a perceptive title to one of my previous blog posts, this is one reason why we need better microfoundations. If I understood nominal rigidities better, I would better understand what sort of supply shocks would shift the SRAS curve relative to the LRAS curve, and would better understand how monetary policy should respond to supply shocks.

How do you teach SRAS shocks?

[Update. Greg Mankiw responds to this post, and links to a 1995 paper (pdf) he wrote with Larry Ball that provides a theory of SRAS shocks. I had read that paper, ages ago, and should have referenced it in this post. I really like that paper. It shows a clear understanding of the SRAS puzzle, and puts forward a fully worked out solution that makes logical sense and is not obviously wrong. (In a lot of macroeconomics, "not obviously wrong" is serious praise.)

Here's the gist of their answer. Real shocks cause changes to equilibrium relative prices. By definition, since we are talking about relative prices, the mean of the distribution of equilibrium relative price changes is zero. But the distribution may be skewed right (a small number of firms should increase their relative prices a lot and a large number of firms should decrease their relative prices a little), or it may be skewed left (vice versa). Menu costs mean firms will only change their prices if the equilibrium relative price change is bigger than a threshhold. So if the distribution skews right, some firms increase their prices and the SRAS curve shifts up. If the distribution skews left, the SRAS curve shifts down.

I think the Ball-Mankiw theory is the best fully worked out theory we've got. Which makes me feel churlish to say -- I still don't really like it. Especially since I can't articulate my reasons very well. But let me try. I don't see how it works in the case of changes in economy-wide indirect taxes, which seem to feed right through into shifting the SRAS curve. I can't help but think about the coordination problems in getting to the new Nash equilibrium in a monetary economy, especially when normal people (i.e. non-economists) can barely think though partial equilibrium experiments, barely understand the difference between relative and nominal prices, and think it goes without saying that of course an increase in oil prices or indirect taxes will cause inflation. And if everybody thinks it will, it will.

How the hell to teach that? "OK, students. You all think that an increase in oil prices will automatically cause the price level to rise. Because the price level is just an average, right? Well, you are all totally wrong. But, because everybody thinks like you, you are in fact right!" And how could I teach Ball and Mankiw in intro or intermediate macro? "Let me first explain the first, second, and third moments of a distribution of equilibrium relative price changes.Yes, this will be on the exam."]

Comments

[Richard Williamson]

Nick,

I'm just a rank amateur playing around with some AS/AD curves... so caveat emptor! But consider an inflation-targeting regime in a world where SRAS shocks are also LRAS shocks. If you put inflation on the vertical axis with a horizontal AD curve, and shift SRAS and LRAS left from equilibrium, whether short-run production is higher or lower than the new LRAS depends on how you draw the SRAS curve. In order to get short-run production below the new LRAS (which would be the 'orthodox' result of a supply shock in an inflation-targeting regime), you have to shift the SRAS 'more' than the LRAS (i.e. bigger Y-Y1 for every price level). That needs a theoretical explanation.

Of which there may be an obvious one. But I'm not an economist and can't think of it. I can tell stories of why I think it *ought* to be the case that we get underproduction as the end result, but that hardly means I understand the SRAS curve.

[RebelEconomist]

I have not read this post; I am still trying to make sense of the previous two, which are more of my interest. But a point I would make is that Nick's uncertainty from the beginning about what he is teaching to undergraduates shows how, in economics at least, teaching is not so detached from research, and there certainly should be a sustainable and respected career for academics who specialise in reviewing, synthesising and filling gaps in what is supposed to be existing knowledge. Above all, academics should be experts in their field, and this kind of thinking has to be at least as good at serving that purpose as trying to build a formal model to prove that something that works in practice can be shown to work in theory too.

[Nick Rowe]

Richard: Yep. In general, there is nothing that says that the SRAS and LRAS curves will always shift sideways by the same amount. Here is one example. Assume nominal wages W are sticky, and prices P are perfectly flexible. Assume standard demand and supply curves for labour, as a function of W/P. Now suppose labour supply increases. The LRAS curve shifts right. But the SRAS curve does not shift at all. If P says the same, and W is fixed, W/P stays the same, so labour demanded stays the same, so employment stays the same, so Y stays the same. You just get unemployment. P needs to rise to get W/P to fall to the new equilibrium.

Rebel: I know it's a cliche about research and teaching going together, and it's often false, but sometimes there's something to it. Having to explain something to someone sometimes makes you wonder whether it really all makes sense.

[Nigel]

Shouldn't you think of the LRAS curve as the locus of the points on the SRAS curves (one such curve for each expected price level) where P = Pe, rather than something that can move independently of the SRAS curves? The LR in this context is an analytic LR not a temporal one: it is defined by the condition that P = Pe and shows you what level of output would be produced at any moment if P=Pe.

And since a SRAS curve with a Pe x% higher is x% higher in height the LRAS is vertical. The LRAS curve is not an entity that is independent of SRAS curves: it is constructed from them.

Thought of in this way the answer to the question "What sort of shock would cause the SRAS curve to shift without causing the LRAS curve to shift?" is: no sort of shock; if the SRAS curve shifts because of a supply shock then so must the LRAS curve - and by exactly the same horizontal amount.

[Nick Rowe]

Damn! It ate my reply to Nigel! Trying again.

Nigel. We often write the SRAS/LRAS curve as, in logs: Y=Y*+B(P-Pe) or P=Pe+(1/B)(Y-Y*) where supply shocks affect Y* (and maybe B too). And the LRAS curve is where Pe=P.

If we do this, then supply shocks *always* shift the SRAS and LRAS curve right and left by *exactly* the same amount. The only "supply shock" that could shift the SRAS curve but not the LRAS curve would be an exogenous shock to Pe, which is strange.

But:
1. This is not what the pictures in the textbooks show. They show "short run supply shocks" shifting the SRAS curve but not the LRAS curve.
2. When I eyeball the monthly data, the world doesn't look like that. After a change in gas prices or indirect taxes, which shouldn't the LRAS curve much, it sure looks like the SRAS curve shifts vertically up by about the amount of the increase in indirect taxes or gas prices. Imagine an idiot accountant whose theory of the CPI was "Well, if gas prices go up 10%, and we spend 10% of our income on gas, then the CPI will go up 1%". Looking at monthly data, that idiot accountant would make rather good predictions.

[david]

The LRAS curve tells us where the economy would be if there were no nominal rigidities.

Well, no. It tells you where the economy would be in the absence of the short-run shock (that made the nominal rigidities matter). Or: where the economy would be in the short-run if the nominal rigidities did not exist and the short-run distortion ended, leaving only whatever hypothesized long-run change in factors of production.

In the absence of additional (later) shocks, LRAS now is the same as LRAS later. That's why it's the "long-run". Model-consistent expectations demand this much of expected LRAS.

LRAS does not, itself, shift in the short-run, unless you discard the hypothesis of trend-stationary GDP growth in the long-run. This latter issue is a wholly empirical dispute, of course. One could readily acknowledge that microeconomic intuition rather suggests a unit root instead of trend stationarity, yet here we are, amidst vicious disagreement in the econometric literature.

[Nick Rowe]

david: I disagree. You can define the LRAS curve that way if you like, and as an econometrician you can estimate LRAS that way if you like, but the LRAS curve defined in your way does not tell us what we need to know for monetary policy.

For example. Take an agricultural economy. It's purely stationary, but there are uncorrelated shocks to the annual weather, which affect the harvest. Your LRAS curve never shifts in this economy, by assumption. My LRAS curve, defined as where the economy would be absent nominal rigidities, shifts back and forth with the weather.

Further assume this economy is perfectly competitive, and has no externalities, except for the nominal rigidity. Optimal monetary policy, conditional on the central bank observing the weather, would be to ensure that Y fluctuates so that Y stays on *my* LRAS curve at all times.

[primedprimate]

This bothers me when I teach as well - I usually say a change in Pe is possible when a highly visible price (such as gas prices on big boards at all gas stations) changes - people's perception of price can change more than the actual change (when deriving SRAS through Pe).

For instance, in an oil shock, I suggest that there is less oil available (for whatever reasons) and as oil features as an input in the aggregate production function, a decrease in the quantity of oil available will show up as a downward swivel of the production function and a corresponding leftward shift of the LRAS. The shift in SRAS is greater because people are 'hyper-aware' of changes in the price of gas (gas prices being displayed prominently and featured on the news etc.) and 'under-aware' of changes in the overall price level.

Also, sometimes I talk about how changes in legal arrangments or bargaining power can be depicted as changes to the 'sticky nominal wage' which will result in a shift of SRAS without affecting (arguably) the LRAS (when deriving the SRAS through nominal wage rigidities).

[Richard Williamson]

Nick,

Do you have a story for why, say, a negative commodities shock would shift the SRAS curve more than the LRAS? As you said a couple of weeks ago, ngdp vs inflation targeting only really makes a difference if there are shocks to AS rather than AD (assuming central bank competence). I always thought inflation targeting gave the "wrong" answer to negative supply shocks (and hence my view that the oil price spike in 08 made things substantially worse). It intuitively makes sense to me that this would be the case (a large negative supply shock to one sector could mandate substantial deflation in other sectors of the economy, which hardly seems efficient) but I would really like a more compelling explanation that translates to the standard graph.

[Nick Rowe]

primed: "This bothers me when I teach as well ..."

I am pleased to hear that! Misery loves company ;-)

Your first story makes good logical sense, but makes me really uneasy.

I'm less sure about your second story. I need to play with some pictures to see if the SRAS curve does indeed shift left more than the LRAS curve.

[Richard Williamson]

Consider an extreme example: all the oil in the world disappears. Would I expect the SRAS curve to shift more than the LRAS curve? Yes, because it would take time to switch to substitutes and reorganise the economy in the most efficient way. So I think there are Austrian-type explanations for why the SRAS might shift more.

[Nick Rowe]

Richard: well, in that post I did a couple of weeks ago, I said that if the nominal rigidity was caused by sticky coordination rather than sticky prices, this sort of thing would likely happen. But I don't have a fully worked out model (and I can't easily see how I could work it out) and it would be hard to explain also. Though maybe not, because I sort of did explain it in that blog post??

[Nick Rowe]

Richard: but in that example, even if there were no nominal rigidities, Y would fall more in the short run than in the long run. That doesn't mean the SRAS curve would shift left more than the LRAS curve shifts. It's like the bad weather example.

[Richard Williamson]

Nick

Sorry, you're quite right. And the sticky coordination story does seem quite convincing.

[Nick Rowe]

Hmmmm. After mulling over primedprimate's first story, it's starting to grow on me. At the very least, it's not totally ad hoc. I'm now wondering how it could be applied to the indirect taxes example.

Richard: OK. But what you said is nevertheless important, I think. Assume a negative AD shock with sticky prices. Y falls. Once Y has fallen, we get hysterisis (for the sort of reasons you described), and that causes both the LRAS and SRAS curves to shift left, and only slowly return to where they were originally. So you get less deflation than you otherwise would after the shock hits, and a slower recovery with higher inflation than you otherwise would. Which looks a lot like the US recently. Plus Canada a bit too.

[primedprimate]

For the second case (legal arrangements), consider the following extreme scenario - a binding minimum nominal wage.

Wouldn't an exogenous change to the minimum nominal wage shift SRAS without shifting LRAS?

The central bank could then potentially shift AD until prices were high enough for the nominal wage to no longer bind in real terms and the economy would be back on the LRAS.

This simplistic SRAS has the additional feature of becoming vertical at the point where it intersects the LRAS (which is where it would have been absent nominal rigidities).

[primedprimate]

In the minimum nominal wage example, I am ignoring the fact that AD would change as well when minimum nominal wage changes (my focus being solely on how the SRAS could shift without shifting the LRAS). But perhaps I am making an error by neglecting AD.

[Richard Williamson]

Nick

YES, demand-driven recessions induce supply side problems. Scott Sumner has mentioned this a couple of times, but it's an under-appreciated point in my view.

As with the bad weather case, the LRAS shifts too. But I'm started to get a similar concern here as I have with IS-LM analysis, which is that the way we do the graphs obscures the underlying dynamic. You have to shift around a lot of curves to represent what is actually happening. I guess that's fine for people who read Econ blogs, but I would imagine causes a lot of problems at the high school / intro college level (and therefore the 'knowledge' of econ that is most widely disseminated) when trying to impart basic understanding.

[Nick Rowe]

primed: I don't think you are making an error by ignoring AD in the minimum wage case. The AD curve defines combinations {P,Y} such that Yd(P,Y)=Y. For a given Y, an increase in W simply changes the distribution of income, which will only change Yd if there are systemic differences in mpc or money demands (depending on your model of AD). And even if it does shift the AD curve, it may or may not shift it the right amount, so it's right to consider the AD curve separately.

I'm not sure I like the minimum wage story though. Sure, you are logically correct. But why would the government and central bank be at cross purposes? The government presumably is trying to increase W/P, and the central bank raises AD to reduce W/P right back again? If the government (or union) has a real wage target, the LRAS curve will shift left too. (But maybe not by the same amount as SRAS). But I think this story could be put together with your Pe story, plus maybe some sort of sticky coordination. The government (or union) can't figure out the general equilibrium effects of a wage increase.

Hmmm. Still thinking.

[Anders]

Nick - apologies to be off-topic but you've closed your "Conflicting Claims Theory" (CCT) post to new comments, and I had a (significant, I hope) point which wasn't covered).

Your exposition of the CCT was rooted in expectations and deserts: it conceived price-setting as being driven by what people think is the "appropriate" price in view of where prices are moving in aggregate. I have two big issues with this.

1. The spread of individual price increases / decreases in the CPI basket of goods is so large that the relevance of inflation in aggregate to individual items looks tenuous at best. If I consider how much I should spend on a first generation iPad today, I certainly won’t look at CPI or any generalised new technology obsolescence curves. It is my consideration of relative value compared with alternatives that will push me to be prepared to extend only to a price that is say 20% below last year's.
2. I struggle to see why expectations matter to individual price-setting decisions. I may believe CPI is going to remain at 5%, but since I don't believe my employer will give me a raise, my expectation seems pretty irrelevant. Conversely, in the early 2000s UK CPI levels (and expectations thereof) were 2%, but this didn't stop people negotiating wage increases in aggregate of 5-7%. It just seems self-evident that people will simply try and charge/pay the most/least they can get away with.

So I would prefer to see the CCT glossed as saying:
1. Every price in the economy of a good or service (consumer prices, B2B prices, commodity prices, and wages) is set reflecting the relative market power of the buyer and seller.
2. Each seller strives constantly to set her price to maximise her gross surplus. This will usually involve maximising price, but will have a view to buyers' price elasticity of demand.
3. Each buyer strives constantly to minimise the price she pays for a good or service. In assessing whether she should accept a given price, a buyer will consider what alternatives are available, switching costs etc.
4. Sellers / buyers do not have regard to expected aggregate inflation, or to what they see as their ‘fair’ share in setting / accepting a price level, but will only focus on the dynamics of the market concerned.
5. Inflation in aggregate will be high when many sellers have sufficient market power vis-a-vis their customers to push through large price increases. Rising inflation obviously has the tendency to thwart what might effectively have been a seller’s attempt to increase her share of real GDP. However, subsequent price-setting dynamics will be informed by market power alone, and not by any ‘disappointment’ felt by the seller.
6. Inflation will be low when (a) a large number of economic actors/sectors lack market power vis-a-vis their customers, and (b) those sectors who do possess significant market power (notably unregulated monopolists such as commodity producers) have already set their price so as to maximise their gross surplus (eg any further oil price would lead to an excessive fall in demand).

Am I missing something? Does this correspond to any existing theory?

Again, sorry to intrude on the SRAS conversation, but if you wanted to re-open the conversation on CCT that would be much appreciated.

[Patrick]

Is the story of oil prices being flexible and other prices being sticky really so unsatisfying? From my perspective, it makes perfect sense. The firm I work for sells stuff, then we make it. Oil is an input (energy, plastics, chemicals, transport, etc ...), albeit an indirect input. There can be a big lag (weeks, months, even years) between signing on the dotted line for $X millions and actual production and delivery. Regardless of what the price of oil does, we're stuck with the price we agreed to when we sold our stuff. I suppose the finance people might be doing some fancy hedging to reduce our exposure to swings in commodity prices, but I don't know. In any case we certainly don't buy oil directly (I think we do buy some metals, but again I'm not sure). In any case our price stickiness relative to oil is quite obvious.

[Nick Rowe]

Anders: No worries. Actually, this is sort of on-topic anyway. The conflicting claims theory of inflation is sort of like a supply-side theory of inflation, and sort of like an SRAS shock.

It's a long time ago I wrote that old post. I'm amazed you've found it. Let me get my head around it a bit later.

[James]

This reminds me of a chapter in my dissertation. In New-Keynesian models, the purpose of the monetary authority is to counteract nominal rigidities. It is not to keep output at its long run average. If a temporary real shock (productivity) were to occur, optimally output should decrease. The marginal payoff to work is less relative to the benefit of leisure, so you take more leisure. However, with sticky good prices output decreases more, since prices cannot rise enough to entice some extra production. If prices were higher, wages could be set higher and entice some people not drop out of the labor market. (of course I speak metaphorically here, there is generally no extensive margin in these models, just intensive). The point being, the recession is deeper with sticky prices. There is an output gap, but the meaning of it is different than what people generally think of. The output gap is relative to the world with flexible prices, not the one with the average productivity (i.e. without the real shock). The monetary authorities counteract the nominal rigidities. This is convenient, since without the nominal rigidities they wouldn’t have ability to impact the economy anyway i.e money would be neutral or equivalently interest rate changes would be instantaneously reflected in nominal prices.

[Rob]

"So the SRAS curve shifts vertically up. Again, the central bank should accommodate that upward shift in the SRAS curve by shifting the AD curve up by the same amount, to prevent a recession."

What would the CB have to target to arrive at this result ? This example seems to imply an additional increase in NGDP is required to prevent a recession so a NGDPT would fall short. And if it was targeting inflation would it not actually worsen the recession by tightening NGDP to squeeze out the additional inflation from the supply-side shock ?

[Phil Koop]

OK, so LRAS does not mean "the aggregate supply we expect to observe in the long run", but rather "the aggregate supply we would observe now in an idealized economy." Likewise, SRAS means "the observed aggregate supply." Why not just come out and say so to your students? Mentally substitute IAS for LRAS and OAS for SRAS.

The weather example seems perversely designed to produce exactly the opposite interpretation: that "long run" means "long run."

[anon]

Anders, 5 and 6 can be seen as negative and positive productivity shocks, respectively. But my guess is that expectations play a role as well: if they are only weakly rational, they could lead to a "sticky expectation" version of the mechanism by which imperfectly competitive actors posting sticky prices can affect overall output (as seen e.g. in NK models). Of course, such expectational mechanisms only matter in the short run, given weak rationality assumptions.

[david]

If you're not really interested in what AS is in the future, then I think you are perhaps instead looking the term "potential output"...? The output gap being your definition of the LRAS less our definition of the SRAS.

[primedprimate]

@Nick: Why are you comfortable with the idea that governments and unions do not realize general equilibrium consequences while remaining uncomfortable with sticky nominal wages (perhaps individual unions bargain in terms of nominal wages and there is a coordination problem across unions?)?

@Phil: That is exactly what I do in class (talk about SRAS as supply with nominal rigidities and LRAS as supply with those rigidities removed).

Next, I tell students that we like to assume that nominal rigidities are flexible in the long run (with long run defined here as the time it takes for those rigidities to become flexible) and use that reasoning to uncomfortably justify the terms SRAS and LRAS.

Finally, I tell them that other existing definitions of short run and long run (calendar time, time it takes for investment to change to usable capital, time it takes for fixed costs to become variable, etc.) will most likely not overlap with the time it takes for nominal rigidities to be nullified.

[RC]

Mankiw offers an answer.

[Chris]

I began reading this post and then stopped. There is a very simple answer:

There is no such thing as a perfectly inelastic long run supply curve.

In the long run we're all dead, and if not, then we are in the future short run.

[AC]

You should really put the update at the end of the post, it makes it hard to follow yours

[Nick Rowe]

RC: thanks. I have added a long update.

Chris: "There is no such thing as a perfectly inelastic long run supply curve." Yes there is.

"In the long run we're all dead, and if not, then we are in the future short run." No we're not.

primed: "Why are you comfortable with the idea that governments and unions do not realize general equilibrium consequences while remaining uncomfortable with sticky nominal wages (perhaps individual unions bargain in terms of nominal wages and there is a coordination problem across unions?)?"

I'm comfortable with sticky nominal wages. I'm less comfortable with the idea that the government would exogenously increase the nominal minimum wage and then sit back and watch while the central bank deliberately pushed the real minimum wage back down again to where it was before.

I strongly agree with the rest of your comment.

david: we are on the same page. But "potential output" has connotations that might be just as misleading as "Long Run equilibrium output". "Potential" suggests some sort of maximum limit. The word "supply" is also wrong, once we move away from perfect competition. And "full employment output" is bad too. Sometimes I think we should just call these curves "Mabel" or "Harry, or whatever.

Rob: "What would the CB have to target to arrive at this result ?"

Good question. I don't have a good answer. NGDP would be better than inflation (or the price level), especially if the SRAS is very flat (which I think it is). But it's still not the right answer.

[Chris]

Ok AC

If there is a LRAS curve, can you please tell me when we're actually in the long run and whether an economy has ever been at a position as represented by a LRAS curve.

I'm sure people who llive in the real world (and not academia - like myself) would like to understand this rubbish.

[Stephen Gordon]

Who peed in your corn flakes? Geez.

[Steve Roth]

Nick: "why would the government and central bank be at cross purposes?"

Isn't this exactly what Sumner and Beckworth claim -- that they are -- and use as (at least one) explanation for why fiscal stimulus is worthless? That the Fed will just counteract any fiscal moves? i.e.:

"if you look at how the Fed actually behaves, rather than what Bernanke says or “really” believes, then you are forced to conclude that the 2009 stimulus was sabotaged."

http://www.themoneyillusion.com/?p=11414

[Steve Roth]

Pls edit "that they do" to "that they are"

[Done - SG]

[david]

I'm up for calling LRAS the Harry curve. ;)

[Prodicus]

As to "how could I teach Ball and Mankiw in intro or intermediate macro?":

If math education were anywhere close to on track in today's high schools and universities, you wouldn't feel any hesitation talking about moments, variance, skew, and kurtosis in any class other than perhaps the freshman Intro to Econ.

[Buyer]

"But it's totally wrong. The LRAS curve tells us where the economy would be if there were no nominal rigidities. A short spell of bad weather would cause the LRAS curve to shift left for a short time, and would cause Y to drop even if there were no nominal rigidities."

Thanks for this. This is something that I think I questioned in your PADM Macro last year (although maybe not so explicitly). I was not satisfied with your answer at the time. But this one makes much more sense to me.

[Taro]

One student asked me why oil shocks shift SRAS to the left and why the prices all rise. I answered that textbook says such that. To be honest, though I am an econ teacher, I dont understand this shift either. Since then, I dont like to teach ASAD model. I teach ISLM /mundell-fleming model only, a little bit on PH/Beverage curve. I would like to study it more since this site, thank you.

[David Backus]

Sounds right to me, but I don't understand the negative tone. You showed pretty clearly that

* We should kill LR from LRAS, it's the wrong terminology.
* It's hard to build dynamics into a fundamentally static framework.

I don't see how this is a bad thing, or that it's inherently about "supply." With luck, you could point students to some interesting issues worth pursuing.

[Doc Merlin]

"OK, students. You all think that an increase in oil prices will automatically cause the price level to rise. Because the price level is just an average, right? Well, you are all totally wrong. But, because everybody thinks like you, you are in fact right!"

Nonsense, even before people thought about overal price levels, increases inelastic goods' prices still caused the mean price level to rise. It has nothing to do with expectations and a lot to do with elasticity. The less elastic the demand for a good is, the larger the income effect a relative price change in that good. This means that even in the aggregate, people are poorer when the supply of gasoline dropps! This income effect will shift the LRAS through investment.

On the other hand, relative price changes in highly elastic goods have very little income effect and the aggregation removes all the substitution effects, so you don't see almost any effect on the AS curve.

Note: I hate the ASAD model because it darkens more than it actually illuminates.

[Doc Merlin]

I realize I missed fully answering your question:

The long run is defined s.t. all goods are perfectly elastic. This is why the LRAS wouldn't shift in your example, because there is no income effect.

Note: Again, ASAD hides more than it illuminates.

[Nick Rowe]

Taro: "Since then, I dont like to teach ASAD model. I teach ISLM /mundell-fleming model only, a little bit on PH/Beverage curve."

The ISLM (or Mundell-Fleming) model is a theory of the AD curve. It needs to be supplemented to be a complete theory of the economy. We need to add a LRAS/SRAS curve to the model. Or, we change the vertical axis from P to pi, and call that second curve the LR/SR Phillips Curve instead of the LR/SR AS curve.

David: welcome! I can't quite articulate my negative feelings over SRAS shocks. The Ball Mankiw model is a good explanation, for example, even if I think it's not quite right. Maybe it's just my frustration with the simplest and most obvious story being wrong ("if the shock is short and temporary it's a SRAS shock!")

Doc: I disagree. The slope of the SRAS/LRAS curve has nothing to do with elasticity in the normal micro sense. In the normal micro sense of elasticity of supply, we are talking about substitution of resources away from producing bananas into producing more apples in response to an increase in the relative price of apples to bananas.

All the micro supply curves could be perfectly elastic, but the AS curve should be perfectly inelastic, absent nominal rigidities.

Maybe I misunderstood you.

[Doc Merlin]

@Nick Rowe:
"All the micro supply curves could be perfectly elastic, but the AS curve should be perfectly inelastic, absent nominal rigidities.

Maybe I misunderstood you."

Yes you did, I didn't mean that the SRAS/LRAS slope depended on micro elasticities. I was saying that the movement of the SRAS/LRAS curves depended on micro elasticities.

[Nick Rowe]

Doc. OK. I'm glad I misunderstood you!

But I still don't understand you. If (say) there's a change in relative demand for goods, why/how would the shift in the LRAS and SRAS curves depend on those micro supply elasticities? (I'm not saying it won't, just not seeing why/how it would).

[Doc Merlin]

I should clarify further. I agree with you that absent nominal rigidities the AS curves should be perfectly elastic. Their movement from relative price changes has to do with the elasticities of the goods or services experiencing the shifts. The SRAS curve will move from these relative effects because the micro demands for those goods are not perfectly elastic. The LRAS curve will not move from relative price changes absent some sort of nominal effect, because in the long run, the micro elasticities are perfectly elastic.

Does that explain what I mean better?

[Doc Merlin]

"If (say) there's a change in relative demand for goods, why/how would the shift in the LRAS and SRAS curves depend on those micro supply elasticities?"

1) A change in relative supply not demand. A change in relative demand for goods would shouldn't shift the LRAS and SRAS curve unless there are rigidities.
2) micro demand elasticities, not supply elasticities.

Where there is a large micro shock, the the micro demand elasticities determine how the new macro consumption bundle is composed. The income effect from this change shifts the SRAS. If the demand elasticities of the goods shifted are very large, then there is no income effect. This shows up in SRAS in the short term people are richer or poorer from this effect, but doesn't show up in AD, because of the the AD is are composed.

[Doc Merlin]

Another way of saying it is, "micro demand elasticities help determine the macro effect of supply shocks."

[Joe Smith]

I do not think you folks have meaningful (or at least common) definitions of:
1) price level
2) real income
3) aggregate supply
4) aggregate demand
5) short run
6) long run

which makes this whole discussion pointless.

[Carl Campbell]

Here is a link to a paper I've written on microfoundations for the aggregate supply curve:

http://mpra.ub.uni-muenchen.de/15296/2/MPRA_paper_15296.pdf

In this paper, it is assumed that firms pay efficiency wages and that worker have imperfect information about the average wage rate. In this version, workers' expectations of average wages are a mixture of rational and adaptive expectations, and a later version of the paper considers a case in which workers' expectations are based on the sticky information model. The maximization of firms yields both a long-run AS curve and a short-run AS curve. In this model, an AS shock (i.e., a shock to productivity or oil prices) will cause the SRAS to shift either less than or the same as the LRAS, depending on the model's parameters. (With a constant-velocity specification, both curves shift equally.) In addition, AS shocks are likely to affect AD, since a positive technology shock is likely to raise consumption and investment, and an adverse oil price shock is likely to do the opposite. Following an adverse oil shock (assuming the country is a net oil importer), it is possible that short-run output will fall more than long-run output (even though the leftward shift in the SRAS is less than or equal to the shift in the LRAS) because of the possibility that the AD curve will also shift left.