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I'm reading through Mishkin "The Economics of Money, Banking, and Financial Markets". In chapter 23 (of the global 13th edition), they introduce the AS/AD framework. What confuses me is the following. Suppose we have a initial scenario

  • LRAS at potential output $100$
  • We observe to be at an output of $110$ which equates to inflatino of $2.5%$. This is where currently the AS intersects the AD.

Clearly inflation is above expectation. They argue that leads to worker demanding higher wages which leads to higher prices and somewhat lower output. This story continues until expected inflation meets inflation, i.e. AS, AD and LARS intersect in one point. This process has shifted the AS curve to the left/upward.

My question: Why is it that in the initial starting point of positive output gap it is the AS curve that adjust. Just looking at the picture couldn't it be that the demand curve shifts to the left/downward so that we intersect in a long run equilibrium with lower inflation?

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My question: Why is it that in the initial starting point of positive output gap it is the AS curve that adjust. Just looking at the picture couldn't it be that the demand curve shifts to the left/downward so that we intersect in a long run equilibrium with lower inflation?

This is because shift in labor supply does not directly affect any parameter that shifts the AD curve. This affects the price level, but changes in price level just result in movement along AD curve not shift in AD curve.

However, when workers due inflation expectation demand higher wages at any quantity of labor supplied, which shifts the labor supply to the left, the whole AS curve shifts to the left as well. This is because SRAS curve is derived from the labor market equilibrium. The graphical derivation of SRAS curve is shown below, if you use the same graph and shift the $L_s$ line to the left and trace all the points you will see that whole SRAS curve shifted to the left as well.

enter image description here

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  • $\begingroup$ Many thanks for your answer. Just one little clarification. If the first reaction is on the supply side, I totally agree that this doesn't affect AD. But why can't we argue: Higher inflation people worried that we will reach cycle peak and start to reduce e.g. consumption. That would shift the demand to the left by basically having a negative outlook on economy. $\endgroup$
    – swissy
    Jan 21, 2023 at 12:14
  • $\begingroup$ @swissy you can argue that, but that was not part of the problem. Two shocks can coexist at the same time. It is not easy to track 2, 3, 4 etc shocks at the same time in this simple graphical analysis so textbook will typically do 1 or 2 at the same time. Once you learn calculus behind the model you can introduce as many shocks as you want and lets say derive impulse response functions. It is empirical question how many shocks occur in some year in some particular country. In this case author of the textbook just assumed there is one shock and the shock is to labor supply on labor market. $\endgroup$
    – 1muflon1
    Jan 21, 2023 at 13:37
  • $\begingroup$ Thanks for the clarification. But am I right (from a learning perspective). Just having the initial state (larger output, higher inflation) I can't say which shock is used to bring it down again, i.e. one needs to say we observe a supply shock etc? $\endgroup$
    – swissy
    Jan 21, 2023 at 14:02
  • $\begingroup$ @swissy yes one does need to say that. Just from observing that output fell its impossible to work back to what happened without directly observing other parts of economy. It would be like finding a dead body and trying to figure out what happened without any clues whatsoever. $\endgroup$
    – 1muflon1
    Jan 21, 2023 at 15:21
  • $\begingroup$ many thanks! very much appreciated! $\endgroup$
    – swissy
    Jan 21, 2023 at 16:00

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