Path Dependent LAS

Here is the story that goes with the figure. At the beginning of the story, Aggregate Supply is SAS₁ from a short run point of view and LAS₁ from a long run point of view. Production is near the intersection of SAS₁ and LAS₁. However, a series of unexpected disasters reduces aggregate demand and production to Y1 one year and further to Y2 in the second year. Perhaps these disasters are like the ones that set off the Great Depression in the 1930's -- a collapse in autonomous consumption followed by further collapses of the banking system, the money supply, and investment. Or perhaps they are like the disasters that struck European economies in the 1970's and set off their periods of high unemployment that have continued to this day; or, yet again, like the disasters that have struck the Asian industrializing economies in 1997. Anyway, they are historically unique and so unexpected, that is: they are surprises, so they cause a movement down the SAS₁ curve to the points indicated by Y1 and Y2.

Figure 7: A Relatively Permanent Reduction in Production

However, since production is highly permanent, production for the next few years can be expected to be relatively close to the numbers for Y1 and Y2, as shown by the dots labeled Y3, Y4, and Y5. But, because people have Rational Expectations and know that production is highly permanent, those low levels of production (relative to LAS₁) do not come as a surprise. Indeed, people would be surprised if production sprang back to the level of LAS₁! Since by definition the LAS is at the unsurprising output level, this is telling us that LAS₁ is no longer the LAS. Instead, the LAS has shifted to something like LAS₂.

When the LAS changes in this way in response to short-run changes and changes in Aggregate Demand, we say that it is "path dependent."

path dependent: If the NAIRGDP depends on the recent levels of production, we say that the NAIRGDP is "path dependent."

If the NAIRGDP does not depend on the past history of production, either because it is very stable or because it depends on other, unrelated causes, then we say that it is "path independent." The NAIRGDP could be constantly changing, and still be path independent, provided that the changes are caused by other factors unrelated to RGDP.

As we have seen, if the NAIRGDP is path dependent, that could reconcile the evidence that (on the one hand) people's expectations are unbiased and (on the other hand) production is highly permanent. And we have some independent evidence that, in fact, supply decisions are path dependent.

Where does that leave us with respect to Policy Ineffectiveness?

Policy Effectiveness