# Nominal shocks/real shocks . . . AS/AD

Our textbooks teach macro in a very strange way.  We often start off the core material with a chapter that discusses the “classical dichotomy.”  We try to convince students that if you double the money supply then all you’ll do in the long run is double the price level.  But we also explain that nominal shocks can have real effects in the short run, as wages and prices are sticky.  We often present the equation of exchange and the quantity theory of money.  And velocity!!

And then we proceed to entirely ignore this framework for the rest of the textbook.  The QTM is treated like a crazy aunt that has to be hidden away in the attic.  Time for more serious stuff!  On to the AS/AD model, and the various components of GDP.  Of course economists understand the linkages between these two approaches; they understand that real shocks are sort of like supply shocks and nominal shocks are sort of like demand shocks.  But not exactly.

Unfortunately students don’t see this at all.  And why should they?  It’s like we started teaching the course in one language they don’t understand (say ancient Greek) and half way through switch over to another language they don’t understand (Latin.)

I have a modest proposal.  If we are going to start the course in Greek, why not continue in that language all the way through?  Why not do inflation and business cycles using the language of nominal and real shocks, instead of AS/AD shocks?  After all (as Nick Rowe frequently points out) all definitions of AD are arbitrary.  So why not pick the one that corresponds to “nominal shocks,” i.e. to changes in M*V?

So our AS/AD models starts out as a LRRO/NS model (that’s long run real output and nominal spending.)  The LRRO line is obviously vertical, and is obviously identical to the LRAS line.  The NS line is a rectangular hyperbola representing a given level of P*Y.  AD shocks (M or V) move the NS line.  We use this model to explain why poor countries can’t get rich by printing money.

Then we move on to business cycle chapters, and bring in sticky wages and prices.  Now we add the SRRO line, which is identical to the SRAS line.  Now we can explain why nominal shocks have real effects in the short run.  We tell students that the SRRO line partitions changes in nominal spending (M*V) into real growth and inflation (P and Y.)

This approach is also a far better way of teaching fiscal and monetary policy.  Both monetary and fiscal policy can, ceteris paribus, impact the NS line.  Some types of fiscal policy also may also be able to impact the LRRO and SRRO lines.

When I presented this idea to a co-author of one of the top principles texts, he seemed quite impressed, and encouraged me to submit it to the Journal of Economic Education.  I never had any luck with that journal, so I’ll present it here instead.  It’s in the public domain now, feel free to submit it to the JEE.

PS. My hidden agenda is that this framework makes it much easier to see what went wrong in 2008-09.

And to make sure it never happens again.

PPS.  The fact that I think in terms of this framework is probably the main reason my blog has become somewhat successful.  I immediately saw what went wrong in 2008.

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18 Responses to “Nominal shocks/real shocks . . . AS/AD”

1. Jeremy H.
3. October 2012 at 05:42

I believe that Cowen and Tabarrok’s Principles text is essentially doing what you are suggesting, with slightly different labels (they call LRRO the “Solow Growth Curve”).

2. ssumner
3. October 2012 at 05:47

Jeremy, But using the same labels is the whole point. One language–all through the book. What do they call AD? (I have the book–but not with me.)

3. Jeremy H.
3. October 2012 at 06:05

AD is called AD, but (from my memory) they constantly emphasize in the text and graphs that it is also nominal income (change in M plus change in V).

4. ssumner
3. October 2012 at 06:16

Jeremy–Well that’s certainly progress. But I still think using ‘nominal’ and ‘real’ on the graph is even better. Makes it clear that we are using the model developed in the MV=PY/QTM/classical dichotomy chapter.

5. Richard A.
3. October 2012 at 07:18

Tabbarrok explains the dynamic aggregate demand-aggregate supply model in Tyler Cowen and Alex Tabarrok’s textbook, Modern Principles: Macroeconomics.

6. Major_Freedom
3. October 2012 at 09:28

Relative spending is more important and more useful than aggregate spending.

1. Imagine an economy of 300 million people that has 5% NGDP growth, and this year’s NGDP is \$20 trillion, where only two people are trading goods and services for dollars, while everyone else is engaging in self-sufficient farming. Now imagine an economy of 300 million people that has 5% NGDP growth, and this year’s NGDP is \$20 trillion, where all 300 million people are trading goods and services for dollars.

2. Imagine an economy of 300 million people that has 5% NGDP growth, and this year’s NGDP is \$20 trillion, where all spending is in the form of consumer goods. Now imagine an economy of 300 million people that has 5% NGDP growth, and this year’s NGDP is \$20 trillion, where spending is 50% consumption and 50% capital and labor.

To analyze, compare and contrast the two economies in each thought experiment above, would relative spending be more useful, or aggregate spending?

The reason why relative spending is more useful in these thought experiments is the same reason why it is more useful in the real world.

7. marcus nunes
3. October 2012 at 10:40

Scott
I remember usinf C&T Macroeconomics even before it was officially released, and at the time I commented with you that it was a “big leap forward”. They kept the traditional nomenclature of As/Ad. LRAS became the Solow Growth Curve, which is fine because it denotes the long run output potential.
The big advance was that everything is in terms of growth rates. No more P,Y graphs but Inflation RGDP growth graphs. The AD gowth curve is labeled AD(money growth+Velocity growth) and changes in AD growth are changes in money and velocity growth.
Old habits die hard. A&T took the first step, defing AD growth as changes in M and V. The next step is to drop the label AD and substitute it for NS growth, which is nothing more than DM+DV

8. marcus nunes
3. October 2012 at 10:57

And ‘coincidentally’, all C&T´s standard AD growth curves are stated in terms of 5% NS growth!

9. Doug M
3. October 2012 at 11:20

“It’s like we started teaching the course in one language they don’t understand (say ancient Greek) and half way through switch over to another language they don’t understand (Latin.)

I have a modest proposal. If we are going to start the course in Greek, why not continue in that language all the way through?”

The Romans think that Latin is better, and the Greeks say no it isn’t. The Romans kick the Greek’s respective butts, and go on to appropriate nearly all of Greek culture and call it their own but with Latin names. Hermes becomes Mercury and transitions from the god of liars, gamblers and thieves to the god of information, markets and economics.

10. Doug M
3. October 2012 at 11:27

The progression as I was taught… Starts from S/D (micro) to AS/AD to C+I+G+X-M to IS/LM and then there is this crazy theory on the side that is growing in influence — QTM.

11. Saturos
3. October 2012 at 23:40

The horrible thing that I came to realize over the years is that most economists don’t think like this, even though it always seemed completely obvious to me. It horrifies me that that author was “impressed” by your suggestion (though it doesn’t surprise me anymore). The fact that you did think in an unmuddled, logically clear way (unlike 90% of economists), not to mention in the way that I thought, is a big part of what sold this blog to me.

To be fair, though, Mankiw’s textbook does explain how the QTM fits in with ISLM – the classical economy is the “special case” of the General Theory where P adjusts instead of Y. But IIRC he doesn’t go so far as to show the LM curve shifting backwards as we move from the short to the long run, or show a vertical LM curve for the long run.

Doug M, yes that sounds like what Keynes did to his predecessors. Except he was the one who abandoned markets and information to liars and gamblers.

Marcus, I would prefer that we taught levels first, before switching to growth rates. It’s more intuitive and easier to learn that way (as i know from reading Bernanke’s textbook), plus you really need to be able to think both ways. If that means more chapters on the same things so be it, as we now know it’s well worth the emphasis.

12. Saturos
3. October 2012 at 23:42

I sill like calling it the “NERO model”. Nominal expenditures and real output. (See if I can get cited in Sumner’s textbook, then I can rub it in Morgan’s face.)

13. ssumner
4. October 2012 at 05:44

Doug, That’s the problem. AS/AD has NOTHING to do with supply and demand, and yet many students and professors think it does.

14. Saturos
4. October 2012 at 06:28

Yes, it gives students the misleading impression that they are derived by summing all the demand and supply curves in the economy. A simple counterexample will show why that cannot be so.

But I think you’re going too far, Scott. This post by Nick Rowe is excellent, and it shows that they have something to do with supply and demand: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/01/ad-as-y-output-gaps-cuba-monopolistic-competition-and-recalculation.html

15. Saturos
4. October 2012 at 07:41

I thought in terms of that framework in 2008 too. But I still backed fiscal stimulus, as I didn’t yet realize that the liquidity trap was a myth.

16. Saturos
4. October 2012 at 07:42

Although I did realize that some amount of money printing had to do something, so… I guess I just deferred to the wisdom of economists who ought to know better, since I didn’t know of any stimulus opponents who were attacking liquidity traps – until I found this blog.

17. TravisA
4. October 2012 at 08:39

Scott, maybe you should put up some graphs explaining your framework. Something like your work study student did in this post:

http://www.themoneyillusion.com/?p=15308

A couple of pictures are worth 2000 words!

18. ssumner
5. October 2012 at 07:54

Saturos, Maybe that was too strong. But the supply curve assumes flexible prices, and the SRAS curve assumes sticky prices. The long run supply curve is often flat, the long run AS curve is vertical. Demand curves slope downward because of the substitution effect. AD curves have no substitution effect.