Macroeconomics in Context, Fourth Edition – Sample Chapter for Early Release
DRAFT
Moving further to the left, the AS curve shows a region in which the economy is
below full employment, perhaps going into recession or recovering from a recession.
The flat AS line shown in Figure 12.3 for this region indicates that, under these
conditions, there is assumed to be no tendency for inflation to rise. Because a
significant amount of labor and other resources are unemployed, there is no pressure
for higher wages or prices. It is also likely that because wages and prices tend to be
slow in adjusting downward, inflation will not fall either—at least not right away.
When the economy is hit not by a regular recession, but by a really deep recession,
such as one experienced in most industrialized countries in 2007-2009 and again in
2020, output is so far below the full employment level that inflation starts to drop, and
may even become negative (deflation). In this situation, demand is so weak that a
large number of companies may fail. Struggling to stay in business, firms are forced
to cut prices in order to maintain at least some sales. Also, in such a situation, workers
and their unions might agree to wage cuts which lowers firms’ costs and allows them
to further reduce their prices. Here, the AS curve in Figure 12.3 slopes downwards
again as a further fall in aggregate demand accelerates the process of disinflation (a
decline in the rate of inflation) or even deflation (an absolute decrease in price levels).
disinflation: a decline in the rate of inflation
2.2 Shifts of the AS Curve: Inflationary Expectations
When people have experienced inflation, they come to expect it. They then tend to
build the level of inflation that they expect into the various contracts into which they
enter. If a business expects 4 percent inflation over the coming year, for example, it
will add 4 percent to the selling price that it quotes for a product to be delivered a year
into the future, just to stay even. If workers also expect 4 percent inflation, they will try
to get at least a 4 percent cost of living allowance, just to stay even. A bondholder who
expects 4 percent inflation and wants a 2 percent real rate of return will be satisfied
only with an 6 percent nominal rate of return.
§
In this way, an expected rate of inflation can start to become institutionally “built in”
to an economy. As a first approximation, it is reasonable to assume that people expect
something like the level of inflation that they have recently experienced (an assumption
that economists call “adaptive expectations”). Thus, inflation can be, to some degree,
self-fulfilling.
Because different contracts come up for renegotiation at different times of the year,
the process of building in inflationary expectations will take place only over time.
Because of the time that it takes for prices and wages to adjust, we need to make a
distinction between short-run and medium-run aggregate supply responses.
The AS curve in Figure 12.3 was drawn for a particular level of expected inflation
in the short run. Before people have caught on to the fact that the inflation rate might
be changing, their expectations of inflation will continue to reflect their recent
experience. In this model, an economy in recession, or on the horizontal part of the
AS curve, will tend in the short run to roll along at pretty much the same inflation rate
as it has experienced in the past. Tight labor and resource markets caused by a boom
could tend to increase inflation, but this will initially come as a surprise to people and
§
As noted in Chapter 11, Appendix A2, the real rate of return equals the nominal rate minus inflation,
r = i – π.