Short run aggregate supply and expectations: a parable approach

This is suitable for a principle of macroeconomics course. Prior knowledge will be earlier topics in elementary micro (prices, supply and demand shifts) as well as macroeconomics, including the basics (measurement of GDP, price indices), as well as the rudiments of aggregate demand fluctuations. It may be conducted after covering the quantity theory of money, but that is not necessary. It is best used after some introduction to the notion of aggregate supply at a very general level.

There are no class size limitations; usual TBL team sizes are ideal, and should be manageable in less than a full class period.

Overview

Students will explain how misperceptions or "nominal wage confusion" can result in an upward sloping short run aggregate supply curve, using a parable modeled by a textbook example. An outline of a parable is provided in the assignment handout which makes the problem usable regardless of the particular textbook. This exercise will help students understand and remember the principles behind short run aggregate supply and thus why real GDP growth and inflation can vary in response to changes in aggregate demand. This is meant to be one of several explanations (e.g. sticky wages, sticky prices) of why real GDP growth responds to changes in aggregate demand, in contrast to the classical understanding. Following (or preceding this) is the treatment of sticky wages and/or prices.

Expected Student Learning Outcomes

Students learn to see how real GDP can fluctuate along with inflation in response to changes in aggregate demand. Students should be able to apply their understanding to various business cycle events. Students will also be able to understand the role of aggregate supply in the context of monetary policy. The role of expectations with respect to demand shocks including monetary shocks should be enhanced. Time permitting students will be able to evaluate the strengths and weaknesses of the explanation

Information Given to Students

The attached file is given to students as well as "big paper" (11 x 17 at an office supply store) on which to draw graphs and write bullet points. The students also have access to the textbook cited in the document.

Short run aggregate supply and expectations (Microsoft Word 2007 (.docx) 14kB Jul10 18)

1. Context:

a. This idea is due to Tyler Cowen and Alex Tabarroks' Modern Principles: Macroeconomics third edition; the basic "parable" idea is theirs. Students will be assigned the appropriate section of the textbook. The problem should be compatible with other texts. An appropriate quotation in the downloadable file allows for this, and gives the flavor of the idea to jump off from. I have provided more description than usual, given that many will use different textbooks.

b. I generally cover the quantity theory of money before this unit (as does this text), but I don't think that is necessary. I also provide a brief outline of the classical theory of aggregate supply, and I think that I useful for context; I repeat the contrast throughout the debriefing comments.

c. I use the aggregate supply/demand model with real GDP growth and inflation, but I think it is compatible with a levels (real GDP, price level) approach without much modification.

d. I use this exercise before treating sticky wages and prices, but the reverse order is likely just as appropriate. For some students sticky nominal wage theory is easier (once they get some feeling for why nominal wage rates might be sticky) and might be done first. In that case, one can simply modify the document for the students by substituting e.g. sticky nominal wage rates where one now finds nominal wage confusion.

e, One could also allow them to use either or both (nominal wage confusion and sticky wage rates) theories for this exercise. Or one could follow up the version as given here with a briefer sticky nominal wage/price version with minor modifications. In that sense this us a versatile exercise.

f. For this problem I tend to emphasize nominal wage confusion, but one can also incorporate other "price confusion": the idea that firms can make mistakes about in the prices of other inputs and goods the owners buy. Student parables can include such features (and if using the Cowen and Tabarrok text, they may without prompting).

g. The TBL procedure requires the "same problem/question" for all teams. Given that student teams are each making up their own parable, this may seem to violate that requirement. Nonetheless the same underlying principles should animate all of the parables, and in that sense, the exercise is attacking the same underlying problem.

2. Debriefing.

a. Presentation is done in gallery walk fashion. I like to prod them to really sell their stories, and discuss the differences/similarities with other gallery walkers.

b. I often take pencil, check off bullet points, but perhaps place a question mark if the model is not general enough, or gets carried away and departs from the analytical underpinning. If the presenter is hesitant in response to a question I move on to other teams, and come back later. I try to reinforce that this is learning process in an encouraging manner (in my experience the parables give rise to opportunities for light hearted jokes).

c. Students are to show the upward sloping SRAS and be able to explain each step of how it works. Bullet points reinforce their explanation.

d. Other gallery walking students can be encouraged to engage the other team reporters, asking how their particular story results in an upward sloping SRAS. They may even challenge them as to why the classical result does not obtain, if – as they have been taught in micro – markets convey information efficiently.

e. Students can become competitive about their parables, but rarely have I experienced anyone who goes beyond the spirit of friendly competition, and they often appreciate their peers' attempts.

f. In the past student parables have ranged from the humorous (thieves break into the printing and engraving office and print off thousands of dollars to hand out, or a similar idea of corrupt central bankers create money undetected by the governing officials), or more serious/current events oriented (teacher strikes in the spring of 2018 lead to large raises and more spending). Yet another example is that of multi-million dollar sports contracts that are spent immediately. For a cautionary note, see point j. below.

g. After the gallery walking is done, I'll reinforce the contrast with the classical model, the potential to address some business cycle fluctuations we have encountered, and refer to upcoming monetary policy/expectations questions. One may want to particularly highlight the importance of expectations.

h. Given the importance of the topic, one could collect the posted papers and make comments for them for the next class session.

i. I try to underscore the macro nature of this problem, that we are not talking about just a baker, tailor, brewer, or whatever characters they have come up with, but that if all or most agents react in the fashion of the parable, then a macro (real GDP, inflation) fluctuation will result. I also contrast this with supply shock effects which I usually cover before this. Underscoring the short run nature of this result is appropriate, as is connection with long run growth/supply.

j. Potential trouble spot to anticipate: Students may generate a problem that works with micro and not macro (e.g. workers buy Hyundai's by diverting their spending from Toyotas, which is just reallocation). This requires some time making the distinction. It is also why I think presenting the quantity theory of money first with a "helicopter drop of money" analogy can be helpful. In your intro remarks I suggest emphasizing that an economy wide effect must be implied in their parables.

k. Following up on the previous point: a similar problem is that all these leave somewhat up in the air how such spending is financed. One can note that such a discussion is very appropriate but for this exercise we want to concentrate on how supply responds (or not) given some shock to AD.

1. Since this is such an important area for business cycle analysis, I give several questions on problem sets that are then graded before testing them on this. I will often start with a very straightforward question such as: "explain why the short run aggregate supply curve is upward sloping" prompting them to assume an AD shock and use both the sticky wage and nominal wage confusion models. I require them to do a full explanation.

2. Other problem set and test questions follow, requiring them to use this thinking in the context of monetary shocks and other demand shocks.