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Nick, here is a capsule version of my "productivity norm" argument, starting with some of your own observations.

"If the SRAS and LRAS curves always shift left (or right) by exactly the same amount, then optimal AD policy is to ensure that the price level (or inflation rate) is unaffected by those "supply shocks". You can think of this as shifting the AD curve left by that exact same amount, or think of it as making the AD curve horizontal. ...But sometimes the SRAS curve seems to shift left (or right) by more than the LRAS curve. Or, if the SRAS curve is horizontal, you can think of the SRAS curve as sometimes shifting vertically up (or down). So the AD curve needs to allow the price level to rise (or the inflation rate to rise temporarily) if you wanted to keep the economy where SRAS and LRAS curves intersect, so Y=Y*."

Productivity shocks all fit the second case. Those shocks consist of two elements: first, a change in goods' average unit costs of production and, second, a corresponding change in the *actual* quantity of goods offered for sale during the relevant period of analysis. The first of these is represented by shifting the LRAS and SRAS schedules vertically; the second by shifting them horizontally. The argument applies, mutatis mutandis, to both one-time (level) shocks and ongoing (growth rate) shocks. Because the horizontal and vertical shifts are proportional, together they move the AS curves along a 45-degree vector. Allowing for a rectangular-hyperbola AD (constant NGDP) schedule, the optimal (natural output preserving) monetary policy response is that of leaving that schedule unaltered, that is, it is for the central bank to stabilize NGDP rather than P.

I'm pretty sure one can come up with exceptions to these arguments. But I believe the burden in the case of productivity shocks should fall on those who imagine that those shocks only shift AS schedules horizontally.

George: I was hoping you might comment!

First, thanks for your book. I enjoyed reading it, but don't think I understand it fully. This might help me understand your argument.

"Productivity shocks all fit the second case." Yes. I got that from your book. Most productivity increases affect only a small percentage of firms, so it's like my second case (except you are considering a fall in costs rather than a rise like in my example). But it's what you say after that where I'm not sure I follow.

Let's take the simplest case where SRAS is horizontal (and LRAS is vertical). Suppose 10% of the firms (all firms the same size initially) have a 10% improvement in total factor productivity. So the LRAS curve shifts right by 1% (assuming no change in total resource employment or in the allocation of resources between firms in the Short Run), and the SRAS curve shifts down by 1% (assuming other firms hold their prices constant, because that's the Schelling focal point, or because they don't hear about the productivity improvements at other firms, which reinforces that focal point). So an unchanged rectangular hyperbola AD curve (an NGDP target) ensures the new equilibrium is exactly where SRAS crosses LRAS.

Is that your argument? If so, I *think* I get it now. It does rest on some simplifying assumptions, but that's OK, because nothing ever holds exactly in the real world, and we're just trying to get in the right ballpark, because central banks aren't omniscient.

Nick, your understanding is close. As I try to argue here and there in the book (see, e.g., pp. 29-40 and 91-98) the argument is actually more robust than the particular assumptions invoked here suggest--that is, those assumptions are sufficient but not necessary. In particular, the argument is not so difficult to generalize to widespread productivity changes; it also goes through for reasonable assumptions of price stickiness. (Calvo pricing is not very reasonable, in part because it completely ignores the fact that firms have no difficulty adjusting prices at once in response to own-productivity innovations--see pp. 36ff.). Making the case that AD must shift in response to productivity-driven AS changes generally requires that one appeal to less realistic assumptions.

"Assuming other firms hold their prices constant." Keep in mind that it is only firms that produce identical products that must ultimately reduce their product prices to conform to those charged by their more productive rivals, and that unless those firms also become more productive the price reduction isn't after all a necessary part of the ultimate equilibrium response. For a competitive industry the response will in that case consist of a gain in market share for the more productive firms, with the others abandoning the market.

As a population ecologist, I want to learn more about SRAS vs. LRAS curves. Population ecologists use similar sorts of diagrams to analyze the qualitative behavior of the dynamical systems we study (well, we used to; it's not a super-popular approach these days...). We call them isocline diagrams. But I've never seen an isocline diagram in ecology that has different isoclines for the short- and long-run behavior of the system. Offhand, it strikes me as an interesting way to study the behavior of dynamical systems with a separation of timescales. Systems that reach some sort of partial equilibrium quickly, but reach full equilibrium only slowly because some state variable(s) changes slowly.

Now would be the time to tell me that I seem to have badly misunderstood the gist of SRAS vs LRAS curves and it would be a complete waste of my time to read up on them. :-)

Jeremy: Hi!

The Short Run vs Long Run distinction in economics is very context-dependent. It's a useful intuitive heuristic that usually helps us understand more complicated systems in a simplified stepwise way.

One example is in micro, where a firm uses 2 inputs (labour L and capital K) to produce 1 output Q. So we have a production function relating 3 variables. Since first year students don't understand multivariate calculus, we normally talk about the "short run", where the firm chooses L (and Q) to maximise profits holding K constant, then we talk about the "long run" where the firms chooses the mix of L and K to minimise costs for a given Q. And to motivate this, we tell the students that L can be adjusted more quickly than K (though this may or may not be true, and the whole procedure is really just a way to explain a 3 variable system looking only at 2 variables at a time).

"Offhand, it strikes me as an interesting way to study the behavior of dynamical systems with a separation of timescales. Systems that reach some sort of partial equilibrium quickly, but reach full equilibrium only slowly because some state variable(s) changes slowly."

What you say there is precisely correct about other examples where we use the SR vs LR distinction. For example, an economist teaching the Malthusian model (the original ecological model??) would almost always talk about a short run equilibrium for wages, births, and deaths, holding population (the state variable) constant, then talk about the long run equilibrium where population has adjusted so wages are at subsistence. And it's exactly the same in the Solow Growth Model, except in this case population is assumed exogenous, and the state variable is the aggregate stock of capital (which only changes slowly with saving and investment).

But the SR vs LR distinction in the example of this post is more complicated and unclear. Imagine there is some stochastic process causing the AD curve to shift back and forth. Like a coin toss. The SRAS curve tells us what happens when the coin lands heads or tails. The LRAS curve tells us what happens when we use a coin that is biased towards heads, or biased towards tails, and people have already learned which way the coin is biased.

Perfect Nick, that's just the roadmap I needed. Thanks!

Nick and George, I have a new post that was inspired by your discussion:

http://www.themoneyillusion.com/should-we-target-total-wages-or-average-hourly-wages/

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