If firms and workers expect the prices to rise, the short run aggregate supply will shift to the left to SRAS2. (https://www.albert.io/blog/what-shifts-aggregate-demand-and-supply-ap-macroeconomics-review/)

In other words, the SRAS will DECREASE. But why? Especially considering that firms react with increased output supplied to inflation in the short run. According to theory of sticky prices such reaction happens because many firms with flexible output prices see increased inflation as chance to rip additional profit in the short run. So why would they decrease quantity supplied at all possible price levels (i.e. shift SRAS to the left) when they expect inflation to increase?


That’s because you are confusing inflation expectation (increases in prices in the future) with just inflation (i.e. increasing prices now). If aggregate prices increase quantity produced would increase. However, an expectation of price increases in future shifts supply curve to the left as businesses will prefer just to hold on the inventory today and sell it in the future at higher price. If you have an apple and you get option of selling it today for 10e or week after for 50e you will probably prefer the latter (ignoring potential behavioral effects such as hyperbolic discounting and assuming rationality). This will shift the supply of apples in the short run to the left.

Similarly when it comes to aggregate demand higher inflation expectations would actually increase demand, because if you expect prices to be high in the future you want to buy stuff you want now.

You should be very careful not to confuse inflation expectations and inflation they work completely differently.

  • $\begingroup$ I don't confuse them, I just wonder why they work differently in this case. If firms use inflation to rip short-term profit according to theory of sticky prices, then why would they decrease their factors of productions when expecting inflation? If anything, they would need to demand MORE of factors of productions, given said factors of production have sticky price. $\endgroup$ – user161005 Feb 28 '20 at 14:39
  • $\begingroup$ @user161005 sorry for the wording then. Also, if firms are expecting inflation they might as well indeed increase the production but supply is based on the prod. supplied to the market. If you prod. 100 apples but are not willing to sell any then supply on the market is 0 (assuming no other prod.). Supply only equals prod. assuming everything produced immediately sold. That’s a valid assumption in static models but not in dynamic ones. In this case supply shifts to the left because at any price companies are willing to supply to the market less if they expect higher prices tomorrow $\endgroup$ – 1muflon1 Feb 28 '20 at 14:45
  • $\begingroup$ Do you mean that firms would produce now with intention to sell later - namely when price level will be higher (i.e. when inflation expected transformed into actual inflation)? $\endgroup$ – user161005 Feb 28 '20 at 14:53
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    $\begingroup$ @user161005 yes at least that’s one easy example of how firms could and often do react that explains the shift. It’s completely consistent to say firms produce more today and less tomorrow but they set their supply to be lower today and higher tomorrow if they find that is profit maximizing strategy which in this case ceteris paribus would be. In fact this is also one of the reasons why firms can increase supply when inflation actually increases even if they don’t face sticky wages - but that’s a whole other not directly related discussion $\endgroup$ – 1muflon1 Feb 28 '20 at 14:58
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    $\begingroup$ @user161005 not deflation but deflation expectations - sorry for nitpicking but it’s big difference, also in case you are studying for exam if you say only deflation or inflation when you mean inflation expectations it would be zero from most teachers so I recommend being very mindful of that it will save you some points and if you plan to be a professional economist it will be very hard to unlearn the wrong way and relearn the proper one $\endgroup$ – 1muflon1 Feb 28 '20 at 17:28

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