Peter Dorman askswhy you don’t see AS/AD being used in the blogsphere, but it is still there at the beginning in textbooks (ht Mark Thoma). Various people have responded, and in most cases I am very puzzled. I think Paul Krugman, as ever, getsto the heart of the issue, but I still puzzled by what he says. My problem is not with any of the macroeconomics, but with what others think is easy or otherwise for students.
As Paul says, the diagram that fits more closely with how macroeconomists think has inflation and not prices on the vertical axis. The Phillips curve is one of the key relationships in Keynesian business cycle analysis. It relates the two variables that policymakers talk about. So it is just natural (and not at all the result of any fetishism) to start with a diagram relating inflation and output.
It is also very easy to give students an intuitive explanation about why there is a short run relationship between inflation and output, rather than prices and output. You just need to explain how, when output exceeds a natural rate, workers want higher real wages, but firms will not concede a lower mark-up, and may want higher profit margins. So we get a wage price spiral which in the short run gives us some particular level of inflation. The fact that the Phillips curve depends on inflation expectations, which could be endogenous in a dynamic way, is again not that difficult for students. In the long run the Phillips curve is vertical, because if output remains higher than the natural rate, expectations about inflation will rise etc etc.
The problem Paul seems to have is with the other curve, which he quite rightly explains tells us about how policy reacts. But why do we need another curve? We can think about monetary policy choosing some level for the output gap, and tell all the stories we want about the past on that basis. OK, maybe that is too much – economists are addicted to mimicking supply and demand. So if you want to derive a ‘demand curve’, just have policy choose the output gap to minimise a quadratic in excess inflation and that gap, subject to the Phillips curve. (Here is a textbook that takes this approach from the start.) This is much easier than deriving the conventional AD curve in output and prices space. [1]
Paul gives two reasons why he still likes AS/AD. First it provides a quick introduction to why demand and supply shocks are different. But can’t you do the same thing by talking about moving along the Phillips curve and shifts to the Phillips curve? Second, he says that one advantage of AS/AD is that it conveys how ultimately the economy is self-correcting through price adjustment. Now I agree it is vital to have the vertical long run Phillips curve there. But in terms of self-correction, I think the AS/AD is downright misleading. It encourages students to think that there is some kind of automatic adjustment of demand to inflation, rather than policy induced adjustment. For every good student who understands that inflation reduces demand because it leads policy makers to increase (real) interest rates, there are as many lazy students who take away from AS/AD that macro is just like the micro they have already learnt, which is a fatal mistake to make.
So I cannot see that AS/AD represents something that is easier for students to understand than the Phillips curve. Instead I would call it something that it is easy for students to misunderstand. Even if they do not misunderstand, starting off with AS/AD forces them to go through an awkward transition phase to get to a place where they can understand what is currently going on. The number of times I have been asked by students ‘do I use the Phillips curve or AS/AD?’ Let us go straight to the Phillips curve, and make our and their lives easier.
[1] Nick saysquite rightly that the more conventional AD curve does tell us about other monetary policy regimes besides money targeting, but of course in the long list he gives inflation targets do not appear. So I’m mystified about why you start students off by telling them how things worked in the (maybe) past, or the (maybe) future, but not the present.
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