Inflation and Aggregate Supply

In the 1930's, when prices were going down, Aggregate Supply didn't seem very important. It was inflation in the second half of the twentieth century that got economists (New Classical and Keynesian both) thinking seriously about Aggregate Supply.

Keynesians tended to sort inflationary surges into two groups:

demand pull

These were the cases in which prices rose because increased demand allowed businessmen to raise both prices and profit margins.

cost push

These were cases in which prices rose because business costs had gone up, and businessmen passed them on to the customers -- with no increase in profit margins. This could be more serious, since the increases in prices could cause further increases in cost, creating an "inflationary spiral."

In explaining "inflationary spirals," though, the New Classical economists put more stress on expectations. The idea was that people, having lived with inflation over a period of years, would eventually come to expect that the inflation would continue.

Keynesian economists had also recognized that expectations were important, but had followed Keynes' own example in assuming that expectations were given, ceteris paribus. But the New Classical economists and their anti-Keynesian predecessors pointed out that people could learn, and by learning would change their expectations.

Thus, in a world of ongoing inflation,

• Even if people didn't learn very efficiently, they would "adapt" their expectations by correcting their mistakes, and eventually come to expect that inflation would continue. This reasoning produced the "adaptive expectations" approach. But this would mean that people could be confused by sudden shifts in government policy, not having time to "adapt" their expectations to the new conditions.
• If people are rational enough to maximize profits and net benefits from consumption -- as we assume in microeconomics -- then they would be rational enough to learn rapidly, and would get it right on the average. This is the "rational expectations" approach. Thus, people wouldn't be fooled by sudden changes in government policy, but would forecast the results of the changes accurately -- on the average.

Definition and Concepts