We know three things about Aggregate Supply:
No less important is the principle that underlies all this: that people react differently to the same events, depending on whether or not the events come as a surprise. This is the difference between "long run" and "short run" aggregate supply; but it goes beyond aggregate supply. Many of the most important events in economics and finance are primarily driven by the surprises. Stock price movements are a case in point. Those who read the financial pages of a major newspaper can remember many cases in which a stock price has risen on bad news -- because the news wasn't as bad as investors had expected. In this case, the surprise is good, even though the news itself is bad.
Thanks to the insights of New Classical economists, we now understand a wide range of the most puzzling economic events as being reactions to surprise. So it should not be a surprise to find that this principle is important in Short run Aggregate Supply. And that is what we do find.
We apply this to the problem of disinflation. When inflation has been going on for some time, people (rationally) expect it to continue. Because they expect inflation, the short-run aggregate supply curve shifts toward higher prices, and that in itself tends to cause inflation. This presents the monetary authority with a tough dilemma: they can "accommodate" the inflation by expanding the money supply, with the result that inflationary expectations and the inflation itself continue, or they can restrain the money supply and reduce the inflation and the inflationary expectations, at the cost of a recession. The recession occurs because the slowing-down of inflation comes as a surprise. Prices rise less rapidly than people had expected. And, being surprised, they react by cutting back production -- which they would not do if they had expected the slowing of inflation.
Next Chapter: Applications of Aggregate Supply and Demand
Copyright